Indicate by check mark
whether the registrant: (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes ý No o

Indicate by check mark if disclosure
of delinquent filers pursuant to Item 405 of Regulation S-K is not
contained herein, and will not be contained, to the best of the registrants
knowledge, in definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any amendment to this
Form 10-K. o

Indicate by check mark
whether the registrant is an accelerated filer (as defined in Rule 12b-2
of the Exchange Act). Yes o No ý

The aggregate market value
of the voting stock held by non-affiliates of the registrant, based upon the
closing stock price of the Common Stock reported on the Nasdaq National Market
on June 30, 2004, was approximately $136,112,286. Shares of Common Stock held
by each officer and director and by each person who owns 10% or more of the
outstanding Common Stock of the registrant have been excluded in that such
persons may be deemed to be affiliates. This determination of affiliate status
is not necessarily a conclusive determination for other purposes.

The number of outstanding
shares of the registrants common stock, par value $0.0001 per share, as
of February 18, 2005 was 18,110,848.

Portions of the registrants definitive Proxy
Statement to be filed with the Securities and Exchange Commission within
120 days after registrants fiscal year end December 31, 2004 are
incorporated by reference into Part III of this report.

This
report contains various forward-looking statements regarding our business,
financial condition, results of operations and future plans and projects. Forward-looking statements discuss matters
that are not historical facts and can be identified by the use of words such as
believes, expects, anticipates, intends, estimates, projects, can,
could, may, will, would or similar expressions. In this report, for example, we make
forward-looking statements regarding, among other things, our expectations
about the rate of revenue growth in specific business segments and the reasons
for that growth and our profitability.

Although
these forward-looking statements reflect the good faith judgment of our
management, such statements can only be based upon facts and factors currently
known to us. Forward-looking statements
are inherently subject to risks and uncertainties, many of which are beyond our
control. As a result, our actual results
could differ materially from those anticipated in these forward-looking
statements as a result of various factors, including those set forth below
under the caption Risk Factors. For
these statements, we claim the protection of the safe harbor for
forward-looking statements contained in the Private Securities Litigation
Reform Act of 1995. You should not
unduly rely on these forward-looking statements, which speak only as of the
date on which they were made. They give
our expectations regarding the future but are not guarantees. We undertake no obligation to update publicly
or revise any forward-looking statements, whether as a result of new
information, future events or otherwise, unless required by law.

We are a leader in the
development, manufacture and distribution of solid-state medical imaging
products and services to physician offices, hospitals and imaging centers for
the detection of cardiovascular disease and other medical conditions. We
designed and commercialized the first solid-state gamma camera. Our initial
focus is the nuclear cardiology imaging market.
We believe this market segment generates revenue of approximately $10 billion
annually in the United States. Our target markets are primarily physician
practices and outpatient clinics, which we believe constitute approximately 25%
of this total market, or $2.5 billion.

By utilizing solid-state
technology rather than bulky vacuum tubes, we believe that our imaging systems
maintain image quality while offering significant advantages, including
mobility through reduced size and weight, enhanced operability and reliability,
and improved patient comfort and utilization. Due to size and other limitations
of vacuum tube cameras, nuclear imaging has traditionally been confined to
dedicated and customized space within a hospital or imaging center. The size
and mobility of our imaging systems enable us to deliver nuclear imaging
procedures in a wide range of clinical settingsphysician offices, outpatient
clinics or within multiple departments in a hospital.

We sell our imaging systems
to physicians, outpatient clinics and hospitals. In addition, through our
wholly-owned subsidiaries, Digirad Imaging Solutions, Inc. and Digirad
Imaging Systems, Inc., which we refer to collectively as DIS, we also
offer a comprehensive and mobile imaging leasing and services program, called
FlexImaging®, for physicians who
wish to perform nuclear cardiology imaging procedures in their offices but do
not have the patient volume, capital or resources to justify purchasing a gamma
camera. DIS provides physician customers with an imaging system, certified
personnel, required licensure and other support for the performance of nuclear
imaging procedures under the supervision of our physician customers. Physicians
enter into annual contracts for imaging services delivered on a per-day basis.
DIS currently operates 31 regional hubs or sites and performs services in 18
states and the District of Columbia.

Our unique dual sales and
leasing distribution model offers physicians, clinics and hospitals versatile
delivery options that appeal to medical establishments of all sizes,
capabilities and imaging expertise. All
of our imaging systems feature reduced size and weight and, with the advent of
our new Cardius-3 dedicated cardiac triple-head camera, physicians can now
choose among single, dual or triple-head cameras in order to accommodate their
practices speed and throughput needs.
The flexibility of our products and our DIS leasing service allows
cardiologists to provide nuclear imaging procedures in their offices to
patients that they historically had to refer to hospitals or imaging centers.
As a result, we provide physicians with more control over the diagnosis and
treatment of their patients and enable physicians to retain revenue from
procedures that would otherwise be referred elsewhere.

2

Nuclear imaging is a
clinical diagnostic tool that has been in use for over 40 years with
reimbursement codes established since 1971.According
to industry sources, 18.4 million nuclear imaging procedures were performed in
the United States in 2003, of which 10.2 million procedures were cardiac
applications, a volume that is expected to grow approximately 8% in 2005. We
believe the growth in nuclear cardiology imaging will be driven by an increase
in coronary heart disease resulting from the aging of baby boomers and the
record rate of obesity and diabetes in all age groups. We estimate that the 2004 growth rate for
nuclear cardiology procedures performed in physician offices was approximately
15%, and that the growth rate in hospitals was approximately 4%. Although these growth rates have slowed
considerably in the last two years, we believe that our imaging systems small
size, mobility, and ability to accommodate physicians varying speed and
throughput needs offer us significant competitive advantages in capitalizing on
this shift in delivery of nuclear cardiology imaging services from hospitals to
physician offices.

The target market for our
products and services is the approximately 30,000 cardiologists in the United
States that perform or could perform nuclear cardiology procedures. To date, we
have sold or provided imaging services through DIS to approximately 600
physicians, or approximately 2% of the cardiologists. In 2004, DIS performed over 89,000 patient
procedures, which constitutes approximately 1% of the cardiac nuclear imaging
procedures we estimate were performed in the United States that year.

We sold our first gamma
camera in March 2000 and we established DIS in September 2000. In fiscal 2004, we had consolidated revenues
of $68.1 million and net income of $0.2 million. We had consolidated revenues of $56.2 million
and net losses of $1.7 million in fiscal 2003, and consolidated revenues
of $41.5 million and net losses of $12.8 million in fiscal 2002. Revenue
from DIS and from our camera sales constituted 65% and 35%, respectively, of our
2004 consolidated revenues, 62% and 38%, respectively, of our 2003 consolidated
revenues and 55% and 45%, respectively, of our 2002 consolidated revenues. We
believe DIS will continue to provide us with recurring annual contractual
revenue and comprise the largest component of our consolidated revenue.

Nuclear imaging is a form of
diagnostic imaging in which depictions of the internal anatomy or physiology
are generated primarily through non-invasive means. Diagnostic imaging facilitates
the early diagnosis of diseases and disorders, often minimizing the scope, cost
and amount of care required and reducing the need for more invasive procedures.
Currently, five major types of non-invasive diagnostic imaging technologies are
available: x-ray; magnetic resonance imaging; computerized tomography;
ultrasound; and nuclear imaging.

Nuclear imaging measures
varying degrees of physiological activity. Physicians use the images and
related clinical information to determine whether to refer patients to more
invasive diagnostic or therapeutic treatments. Nuclear imaging is provided
through two primary technologies: gamma cameras and dedicated positron emission
tomography, or PET, machines. The most
widely used imaging acquisition technology utilizing gamma cameras is single
photon emission computed tomography, or SPECT.
All of our current cardiac gamma cameras employ SPECT.

According to industry
sources, despite the improved image quality of PET machines, gamma cameras
continue to be used for a substantial majority of nuclear imaging procedures.
We believe this preference is due to the lower purchase and maintenance costs,
smaller physical footprint and easier service logistics of gamma cameras. In an
emerging trend in oncology and, to a lesser extent, in cardiology, SPECT and
PET technologies are being integrated with computed tomography, or CT, to form
hybrid imaging modalities known as SPECT/CT and PET/CT. Hybrid imaging is believed to be advantageous
because it combines the anatomical image benefits of CT with the functional
information offered by SPECT and PET into a single image, although hybrid
systems are substantially more expensive than gamma cameras.

Nuclear imaging is used
primarily in cardiovascular, oncological and neurological applications. Nuclear
imaging involves the introduction of very low-level radioactive chemicals,
called radiopharmaceuticals, into the patients body. The radiopharmaceuticals
are specially formulated to concentrate temporarily in the specific part of the
body to be studied. A system comprised of a gamma camera detector and computer
is then used to detect the radiation signal emitted by the chemicals and to
convert that signal into an image of the body part or organ. Nuclear imaging,
in contrast to other diagnostic imaging modalities, shows not only the anatomy
or structure of an organ or body part, but also its functionincluding blood
flow, organ function, metabolic activity and biochemical activity. According to
industry sources, the following nuclear imaging procedures were performed with
gamma cameras in the United States in 2003:

Cardiac
Applications. Approximately 10.1 million
procedures were performed in cardiology to provide diagnostic information concerning
the flow of blood to, through and from the heart as well as the condition of
the heart muscle.

3

Non-Cardiac
Applications. Approximately 8.3 million
procedures were performed in oncology and organ imaging to provide diagnostic
information on tumor location and size or on the condition and function of
various organs.

We believe that
nuclear cardiology procedures performed annually in the United States with
gamma cameras generate revenue of approximately $10 billion. Our target markets
are primarily physician practices and outpatient clinics, which we believe
constitute approximately 25% of this total market, or $2.5 billion. The market for gamma camera sales across all
care settings in the United States within this total market is estimated to be
approximately $450 million annually.

According to industry
sources, nuclear cardiology procedures are expected to grow by approximately 8%
annually through 2005. We believe the
growth of these procedures will be driven by an expected increase in coronary
heart disease. According to the American Heart Association, this increase in
heart disease will result from the aging of baby boomers and the record rate of
obesity and diabetes in all age groups.

Increasingly, a nuclear
cardiology procedure is the first non-invasive, diagnostic imaging procedure
performed on patients with suspected heart disease. Following the imaging
study, the physician will determine whether there is a need for more invasive
and expensive diagnostic procedures or therapeutic treatments. These treatments
may include angiography, which is an x-ray procedure by which catheters are
inserted into an artery or vein to take pictures of blood vessels; angioplasty,
which is a procedure by which catheters with balloon tips are used to widen
narrowed arteries; or open heart surgery. Given the clinical advantages of
nuclear cardiac images, many payors require patients to complete a nuclear
cardiology procedure before undergoing more invasive diagnostic procedures and
therapeutic treatments.

We believe that our position
as a market leader in the nuclear cardiac imaging market is a product of the
following competitive strengths:

Leading
Solid-State Technology. We were the first company to
develop and commercialize solid-state technology for nuclear imaging
applications. We have continued to introduce new products and to develop our
manufacturing capability and intellectual property. We believe the mobility of
our imaging systems has accelerated the shift of nuclear cardiology procedures
from hospitals and imaging centers to physician offices.

Mobile
Applications Through Reduced Size and Weight. Our solid-state
technology has allowed us to reduce the size and weight of gamma cameras,
resulting in the only in-office mobile cardiac gamma cameras on the market.
Some of our cameras weigh less than 450 pounds and our imaging chairs weigh
less than 350 pounds. The imager and
chair of our largest, high performance, triple-head Cardius-3 imager weigh a
combined 715 pounds, and the accompanying acquisition and processing station
weighs 450 pounds. Our dedicated cardiac
imagers require a floor space of only seven feet by eight feet and generally
can be employed without facility renovations. As a result, our mobile imaging
systems can be easily moved within a hospital or imaging facility, or by van
between physician offices. In contrast, vacuum tube cameras typically weigh
2,400 to 5,000 pounds, are difficult to move and often require a dedicated room
and facility renovations such as reinforced floors.

Image
Quality. Digirads recently launched, high
performance triple-head system offers high count imaging statistics in less
time for optimal imaging efficiency and quality. We believe that our mobile imaging systems
produce a high-quality image despite the rigors of a mobile environment. In
addition, our imaging chair places the patient in an upright position, which
reduces the potential for certain types of false indications of an organ
defect. Most vacuum tube cameras require patients to be imaged while lying on
their backs. In this position, the diaphragm does not descend and may push
other organs up against the apex of the heart, which may result in false indications.
We believe that we mitigate this problem through our upright patient
positioning.

Enhanced
Operability and Reliability. We believe our
imaging systems provide improved workflow, better power efficiency and
increased reliability as compared to vacuum tube cameras. Our gamma cameras do not require continuous
power and are ready to image minutes after being turned on. In contrast, competitive systems must be
powered continuously to stabilize the temperature of multiple vacuum tubes. In
addition, our solid-state technology is more mechanically durable than vacuum
tubes, which are more likely to change their performance characteristics if
they sustain physical shocks during transportation. The small size and light
weight of our detector heads and the modular design of our cameras also
facilitate repairs and upgrades in the field, which are often accomplished by
delivering replacement components overnight.

4

Improved
Patient Comfort and Utilization. We believe the
upright and open architecture of our patient chair can reduce patient
claustrophobia and increase patient comfort when compared to traditional vacuum
tube-based imaging systems. The majority of other imaging systems require the
patient to lie flat and have detector heads rotate around the patient, creating
a more confining environment and potentially increasing the time it takes the
patient to enter and exit the system. Depending on the patients physical
condition, we believe the time savings available with our upright imaging may
increase productivity by as much as one additional patient per day. Additionally, with the availability of our
Cardius-3 triple-head imager, clinicians have the capability to perform
sub-seven minute image acquisitions for more optimized workflow, resource
utilization and patient comfort.

Unique
Dual Distribution. We have implemented a unique dual
distribution model by offering our physician and hospital customers
alternatives methods of using our imaging systems. We sell imaging systems to
physicians and hospitals that wish to perform nuclear imaging in their
facilities and manage the related service logistics. Through DIS, we also offer
our FlexImaging® services to physicians and hospitals on an annual basis in
flexible increments ranging from one day per month to several days per week.
DIS allows physicians and hospitals to offer nuclear imaging procedures to
their patients without the capital investment, certified personnel, required
licensure and other logistics associated with operating a nuclear imaging site.

Intellectual
Property Portfolio. We have developed an intellectual
property portfolio that includes product, component and process patents
covering various aspects of our imaging systems. As of December 31, 2004, we
owned 23patents issued in the United States
and two patents issued internationally. We also have 14 additional patent
applications pending in the United States and 24 applications pending
internationally. In addition to our patent portfolio, we have developed
proprietary manufacturing and business know-how and trade secrets that we
believe provide us with a competitive advantage.

DIS offers a comprehensive and mobile imaging leasing
service, called FlexImaging®, which includes an imaging system, certified
personnel, required licensure and other logistics for the performance of
nuclear imaging procedures under the supervision of physicians. DIS allows
cardiologists to provide nuclear imaging procedures in their offices to
patients they historically had to refer to hospitals or imaging centers. As a
result, DIS provides physicians with more control over their patients
diagnosis and treatment as well as incremental revenue opportunities.
Physicians can tailor their nuclear imaging expenses to their practice needs
and patient volumes.

Under our FlexImaging
program, we provide a mobile camera, a state-certified nuclear medicine
technologist and a certified cardiographic technician or registered nurse. We also provide the radiopharmaceuticals,
pharmaceutical stress agents and related radioactive materials licensure and
supervision for radiation safety services.
All imaging procedures are administered under the physicians
supervision. In 2004, we introduced a leasing program called DigiTech TM
Professional Services that allows physicians who have purchased a Digirad
camera to lease all of the components of our FlexImaging program with the
exception of the camera. In the latter
half of 2004, the DigiTech program was rapidly accepted by our customers and
therefore constituted a higher-than-anticipated share of our overall DIS
revenues at lower margins. Recognizing
the value that the DigiTech program brings to customers, we have now re-priced
the program and anticipate this action to result in higher per-day revenue and
margins in the future..

DIS currently performs
services in 18 states and the District of Columbia and has over 300 contracts
with physicians, most of whom are office-based cardiologists. DIS also provides
leasing services to internists, hospitals and clinics. Our DIS operations use a
hub and spoke model in which centrally located regional hubs anchor multiple
van routes in the surrounding metropolitan areas. As of December 31, 2004,
we had a total of 204 employees in our DIS business operating 31 hubs and
sites and 71 cameras. We have invested substantial resources in developing our
service infrastructure, which includes radioactive materials licensing, a staff
of radiation safety officers and licensed clinicians, coordinated billing
services and standardized lease agreements. We believe that our service
infrastructure and know-how will support additional routes and imaging
modalities in the future and will provide a significant barrier to entry to
competitors.

DIS has policies and procedures for the handling of
radioactive materials, purchasing relationships, clinical training and quality
assurance that we believe maximize operational efficiency and improve customer
satisfaction. We have implemented a compliance plan to help ensure adherence to
applicable state and federal regulations, including Medicare regulations. We
also have an active quality assurance and control program designed to optimize
service and follow strict radiation safety and training programs. Our
management team has developed experience in hiring and training clinical staff
as well as providing quality services to our customers.

At our DIS hubs, technicians
load the equipment, radiopharmaceuticals and other supplies onto specially
equipped vans for transport to the physicians office, where the technicians
set up the equipment for the day. After quality assurance testing, and under

5

the physicians supervision, a technician will
gather patient information, inject the patient with a radiopharmaceutical and
then acquire the images for review by the physician. The technicians furnish
the physician with applicable paperwork and billing information for all
patients and clean the utilized areas before departing.

As of December 31,
2004, we provided FlexImaging leasing services to all of our DIS customers
under annual contracts for services delivered on a per-day basis. These
contracts decrease our immediate and direct dependence on physician
reimbursement. Under these agreements, physicians pay us a fixed amount for
each day that they lease our equipment and personnel, and they commit to the
scheduling of a minimum number of lease days during the one-year lease term.
The same fixed payment amount is due for each day regardless of the number of
patients seen or the reimbursement obtained by the physician. Until August
2004, we also offered a mixed bill option, under which we provided the
technical component of our services and billed either the physician or the
patients third party payor, including Medicare, directly, and so remained at
direct reimbursement risk. As of
December 31, 2004, less than $65,000 billed directly to Medicare under the
phased-out mixed bill option remained outstanding.

We believe DIS allows us to avoid the often lengthy
and sometimes unpredictable sales cycle associated with capital equipment sales
in a hospital or physician practice setting, and provides us with recurring
contractual revenue. Occasionally, DIS customers purchase our imaging systems.
Such purchases decrease our DIS revenues but increase our camera sales
revenues. In addition, because we own
the product that we lease, we have at times been able to translate technical
camera improvements into increased margins in our DIS business. For example, we recently introduced the
Cardius-3, our triple-head camera that features high count imaging statistics
and higher patient throughput. We
believe that our mobile version of the Cardius-3 now under development, subject
to its successful beta-testing in the first half of 2005 and incremental
roll-out into DIS in the second half of 2005, may result in improved revenue
and higher margins in DIS.

Most gamma cameras use a
scintillation crystal, or scintillator, to convert the energy of a gamma ray
photon into light. This light is then converted by means of a photodetector
into an electrical signal which is reconstructed into a diagnostic image. Most
traditional gamma cameras use a single crystal sheet as the scintillator and
use vacuum tube photomultipliers as their photodetectors, which are referred to
as vacuum tube photomultipliers. This basic approach has not undergone any
fundamental change in over 40 years.

Each vacuum tube is
approximately the size of a soft drink can.
Since a detector can consist of up to 60 vacuum tubes, the result is a
camera with both a large detector enclosure and significant weight due to the
lead shield that is required around the detector enclosure. In addition, vacuum
tubes cannot be easily moved or used in a mobile environment because vibration
may change the electrical properties of the tubes or break them. Further,
vacuum tubes may lose their vacuum over time, resulting in reduced reliability.

We introduced the first
solid-state gamma cameras to the nuclear imaging market in
March 2000. In July 2003, we
launched our third-generation Solidium detector, which improved the
reliability and sensitivity of our gamma cameras as well as reducing their
cost. Our imaging systems utilize a
proprietary photodetector which incorporates a silicon semiconductor, or
photodiode, that detects light and converts it into an electronic signal for
reconstruction into a diagnostic image. Our photodiode replaces the vacuum
tubes used in traditional gamma cameras. The size and thickness of our
photodiodes is approximately that of a dime, which enables us to build detector
heads that are significantly smaller and lighter than the detector heads in
traditional gamma cameras. Our solid-state photodiodes are durable, do not
change their electrical properties as a result of vibration associated with
transportation and are more reliable over time than vacuum tubes. These properties
allow our imaging systems to be mobile.

Although photodiodes have
been used for many years in varying applications, their use in gamma cameras
was previously unsuccessful because performance and functionality limitations
prevented the development of a commercially viable product. When a gamma ray
emitted from a patient strikes a scintillator, only a very small amount of
light is generated, and an even smaller electrical signal is produced in the
photodiode. Traditional photodiodes were able to produce detectable electrical
signals only at very low temperatures, typically less than -20° Celsius, due to
the electrical noise inherent in the photodiodes. The equipment and cost
required to maintain this low temperature prohibited commercialization of a photodiode-based
gamma camera. Our proprietary photodiode is capable of producing these
measurable small electrical signals at near room temperature, which reduces
cost and improves reliability.

Our photodiode is packaged
with our segmented scintillation crystal and readout electronics into a
patented detector module. The segmented scintillation crystal allows our module
to achieve higher gamma ray detection rates than the single crystal sheet used
in traditional gamma cameras. We believe the improved detection rates will be
useful with new molecular imaging compounds that we anticipate being introduced
into the market. The entire module is designed so that it can be physically
joined to other modules in

6

varying sizes and shapes, allowing for the
design of large field of view and application-specific imaging systems.

We sell a line of
solid-state gamma cameras and accessories offering both general nuclear imaging
and specific clinical-application imaging. In a typical nuclear cardiology
procedure, the physician acquires two images from the patient, one while the
patients heart rate is at rest and the other after the heart has been
stressed. The procedure begins with the injection of a small amount of
radiopharmaceutical. A patient imaged by our gamma camera sits in an imaging
chair and places both arms on a shoulder-level armrest. The chair is adjusted
to align the patients heart on the axis of the chairs rotation.

Following positioning of the
patient, image acquisition begins with the patient slowly rotating in front of
the cameras detector head, which has also been positioned at heart level. The
duration of the acquisition is a function of the patients body mass, whether
the test is performed with the heart at rest or under stress, the amount of
radiopharmaceutical and the number of camera detectors on the system.

Stress images are acquired
by stressing the heart, either through exercise or the use of other
pharmaceuticals, and then injecting the radiopharmaceutical at the peak stress
level. The difference between a resting and stress image allows the physician
to determine the level of cardiac function. At the conclusion of the image
acquisition process, the chair is rotated to the exit position and the patient
steps out. After collecting the images, the technologist performs the image
reconstruction, checks the quality of the images and further processes the
images. The physician then reviews the images and determines whether more
invasive diagnostic procedures or therapeutic treatments are necessary.

Each of our imaging systems
fits into a seven foot by eight foot room, and the systems generally do not
require expensive room modifications or electrical changes. We currently offer the following products:

The Cardius-3 imager is a
stationary, triple-head gamma camera with an upright imaging chair designed for
dedicated nuclear cardiology applications and high-procedure volumes. The
Cardius-3 imager features three proprietary, third generation Solidium solid-state
detector heads that provide high count imaging statistics, enhanced image
quality and higher patient throughput.
Capable of sub-seven minute stress acquisitions, the system is well
suited for high volume cardiology practices, large hospitals and busy
outpatient imaging centers. This product
is the only dedicated cardiac triple-head camera currently on the market.

The Cardius-2 imager is a
stationary, dual-head gamma camera with an upright imaging chair designed for
dedicated nuclear cardiology applications.
The Cardius-2 features two of our proprietary Solidium detector heads
with excellent image quality and workflow efficiency. The Cardius-2 imager is well-suited for
mid-sized cardiology practices and hospitals.

The Cardius-1 imager is a
single-head gamma camera and patient chair designed for dedicated cardiology
applications and lower procedure volumes;
can be configured as either a mobile or a stationary system. The Cardius-1 also features our Solidium detector and can be upgraded to a
dual-head Cardius-2 by using our upgrade kit. This upgrade feature allows
physicians to expand imaging volume as their practices grow and imaging needs
increase. DIS uses a mobile version of
the camera, the Cardius-1M, to provide in-office imaging services to its
physician customers. We began deploying
the Cardius-1M imager in lieu of the SPECTpak PLUS imager in mid-2004.

The 2020tc imager is a mobile, single-head
gamma camera that is compact and lightweight. The camera is used for general
purpose imaging procedures taken from a single point of view, referred to as
planar, ranging from bone scans to thyroid imaging. The small pixel size in our
2020tc Imager provides improved
imaging resolution over traditional planar cameras. We sell this camera to hospitals
as a secondary camera to increase their capacity and flexibility to image
within multiple departments using a single asset.

The
SPECTpak PLUS imager combines our
2020tc imager and SPECTour patient chair and provides both general
purpose nuclear imaging and cardiology imaging, with the added flexibility of
mobility. DIS® has historically used the SPECTpak PLUS imager to provide mobile
imaging services to its physician customers.
Although DIS still uses the SPECTpak PLUS imager to provide mobile imaging
services to some of its physician customers, beginning in 2004, all new units
deployed by DIS were Cardius-1M imagers.

Workstations, Connectivity and Accessories. We
offer a line of high-performance workstations equipped with multiple software
options for nuclear image interpretation. We also sell connectivity between
imagers from the same or different manufacturers to physicians who wish to
integrate studies from multiple imagers into one single workstation or archive.
In addition, we offer a line of accessories including hot lab equipment
required for the use of radiopharmaceuticals, and various other supplies.

We intend to continue to
expand our business, improve our market position and increase our revenues and
profits by pursuing the following business strategies:

Continued
Innovation in Solid-State Imaging Technology. We intend to
maintain our leadership position in solid-state imaging technology and software
by continuing to invest resources in research and development. We believe we
can continue to improve upon our existing technology to enhance image quality,
improve user experience, maximize patient throughput, lower system cost and
facilitate the ease of maintenance and repairs.

Expand
Our DIS Business. We plan to expand our DIS business into
several new states, add new hub locations in states in which we currently
operate, and increase hub utilization with additional physician customers and
routes. We also intend to pursue
cardiology opportunities for DIS in hospitals and, longer term, new clinical
applications for DIS in neurology, oncology and surgery.

Increase
Market Share in Camera Sales. We believe that
we can grow our market share by capitalizing on the recent trend of nuclear
cardiology procedures shifting from the hospital to the physician office. We
are also expanding our hospital sales and marketing efforts to capitalize on
the increased demand for secondary mobile cameras. We intend to focus our efforts on increasing
our international presence once all appropriate international certifications
are in place.

As of December 31, 2004, our
direct domestic sales organization consisted of 36sales
positions, including four regional directors, 12 territory managers responsible
for capital equipment sales, and 20 imaging sales professionals responsible for
DIS geographic regions. We select our sales representatives based on their
expertise in imaging product sales and services. Each sales representative is
subject to periodic performance reviews and is required to attend periodic
sales and product training. We employ sales specialists to assist territory
managers with in-office or on-site camera demonstrations. We intend to increase
the number of sales representatives as we launch new products and services and
to increase our marketing efforts for existing products. Our experienced marketing organization
performs product development, product management, and marketing communication
functions for both the service and product segments of our business.

We also sell our imaging
systems in four states and Puerto Rico through three distributors and one
independent sales agent. We also have a
distributor in Russia whose distribution arrangement is exclusive. We select our distributors based on their
expertise in imaging systems and sales coverage. These relationships provide
the distributor with the right to sell our products within their sales
territory, and their sales representatives typically attend the same sales and
product training as our own sales representatives. We often service our domestic customers
remotely through high-speed Internet access and dial-up connections that facilitate
system diagnosis without the need for field service or repair. When repair is
required, our modular part replacement capability allows our field service
engineers to perform field repairs that minimize customer downtime. We also
employ applications specialists and a connectivity engineer to train our
customers or provide technical support on the use of our products. We plan to
engage outside service firms to support our international customers.

We have been manufacturing our cameras since
March 2000. The key components of our cameras mechanical and electrical
systems are designed or configured by us, and include a computer (for both the
camera and the stand-alone workstations), cooling systems, liquid crystal
display, controller boards and a data acquisition and communication system. Our
manufacturing strategy combines our internal design expertise and proprietary
process technology with strategic outsourcing. The key components of our
cameras mechanical and electrical systems are designed or configured by us. We
perform subassembly and final system performance tests, packaging and labeling
at our facility. We provide connectivity solutions which include consulting,
configured computers and outsourced electronic image management systems. We
also sell accessories which are outsourced and include printers, equipment for
handling and measuring radioactive materials and software for the camera.

Suppliers of critical
materials, components and subassemblies undergo ongoing quality certification
by us. Most components used in the product are available from multiple sources;
however, we do not currently maintain alternative manufacturing sources for
certain components of the detector or for the imaging processing software. For
those components for which we have only a single source supplier, we are
currently qualifying or seeking secondary sources. We use enterprise resource
planning and collaborative

8

software to increase efficiency and security
in handling of material and inventory, centralizing our purchasing procedures,
monitoring our inventory supplies and streamlining our billing methods. Our
outsourcing strategy is targeted at companies that meet the standards of the
FDA and the International Organization for Standardization, or ISO.

We and our third-party
manufacturers are subject to the FDAs Quality System Regulation, state
regulations such as the regulations promulgated by the California Department of
Health Services, and regulations promulgated by the European Union. In 2004, we
completed the process of relocating and consolidating our manufacturing
operations to a new facility in nearby Poway, California that has been licensed
by the California Food and Drug Branch. Our facilities and the facilities of
our third-party manufacturers are subject to periodic, unannounced inspections
by regulatory authorities, and may undergo compliance inspections conducted by
the FDA and corresponding state agencies.

In late 2004, we received
certification to the ISO-13485 quality standard. ISO-13485 establishes a
quality system tailored for medical device manufacturers and is promulgated by
the ISO. ISO certification is generally required for a medical device
manufacturer to distribute products in the European Union.

As of December 31, 2004, our
research and development staff consisted of 22 employees. We have a long and
extensive commitment to research and development, including an established
history in developing innovative solid-state gamma cameras.

The following are some of
the critical research and development milestones we have achieved:

 In March 2000, we launched the first
solid-state gamma camera for medical use;

 In September 2002, we released the first
dual-head, solid-state camera;

In
July 2003, we launched our third-generation Solidium detector, which
improved the reliability and sensitivity of our gamma cameras as well as
reducing their cost; and

 In September 2004, we released the
Cardius-3, the first dedicated triple-head cardiac camera.

We have an established core competency in the
development of silicon photodiodes and related scintillator assemblies and
signaling processing electronics, which are the core of our gamma cameras.

Our research and development efforts are primarily
focused in the near term on developing further enhancements to our existing
products as well as developing our next-generation products. Our objective is
to increase the image quality, sensitivity and reliability of our imaging
systems and their clinical and economic benefit to our physician customers and
their patients.

The medical device industry,
including the market for nuclear imaging systems and services, is highly
competitive, subject to rapid change and significantly affected by new product
and service introductions and market activities of other industry participants.
In selling and leasing our imaging systems, we compete against several large
medical device manufacturers, including Philips Medical Systems, General
Electric Healthcare, Siemens Medical Systems and Toshiba Medical Systems. All
of these competitors offer a full line of imaging cameras for each diagnostic
imaging technology, including x-ray, MRI, CT, ultrasound and nuclear medicine,
and certain competitors have recently introduced SPECT/CT and PET/CT hybrid imaging. The
existing nuclear imaging systems sold by our competitors have been in use for a
longer period of time than our products and are more widely recognized and used
by physicians and hospitals for nuclear imaging. Many of our competitors and
potential competitors enjoy significant competitive advantages over us,
including:

significantly
greater name recognition and financial, technical and marketing resources;

additional
lines of products and the ability to offer rebates or bundle products to offer
discounts or incentives; and

greater
resources for product development, sales and marketing.

9

We are aware of certain
major medical device companies that are attempting to develop solid-state gamma
cameras, and we believe these efforts will continue. However, we are currently
not aware of any other solid-state gamma camera used for cardiac applications
that has been manufactured or is available in the market. We are aware of a
privately-held company, Gamma Medica, which is currently marketing a solid-state
gamma camera for breast imaging although we do not believe that this camera can
be used in a cardiac application. However, we cannot assure you that Gamma
Medica will not attempt to modify its existing camera for use in the cardiac
segment in the future or develop another gamma camera for cardiac applications.

In providing our mobile
leasing services, we also compete against businesses employing traditional
vacuum tube cameras that must be transported in large trucks and cannot be
moved in and out of physician offices. Competitive fixed-site services may
require extensive or dedicated space and room renovations that result in
increased start-up and ongoing costs. In
addition, we compete against a small number of physicians who have established
their own mobile imaging businesses using our cameras.

Because of the size of the
potential market, we anticipate that companies will dedicate significant
resources to developing competing products and services, including a mobile
leasing service. Current or future competitors may develop technologies and
products that demonstrate better image quality, ease of use or mobility than
our nuclear imaging systems. Our nuclear imaging systems or leasing services
may be rendered obsolete or non-competitive by technological advances developed
by one or more of our competitors. Our ability to compete successfully will
depend on our ability to develop proprietary products that reach the market in
a timely manner, receive adequate reimbursement and are safer, less invasive and
less expensive than alternatives available for the same purpose.

We believe that the
principal competitive factors in our market include:

We rely on a combination of
patent, trademark, copyright, trade secret and other intellectual property
laws, nondisclosure agreements and other measures to protect our intellectual
property. We believe that in order to have a competitive advantage, we must
develop and maintain the proprietary aspects of our technologies. We require
our employees, consultants and advisors to execute confidentiality agreements
in connection with their employment, consulting or advisory relationships with
us. We also require our employees, consultants and advisors who we expect to
work on our products to agree to disclose and assign to us all inventions
conceived during the work day, using our property, or which relate to our
business. Despite any measures taken to protect our intellectual property,
unauthorized parties may attempt to copy aspects of our products or to obtain
and use information that we regard as proprietary.

We have developed a patent
portfolio that covers our overall products, components and processes. As of
December 31, 2004, we had 23 issued U.S. patents and 38 pending patent
applications, including 14 U.S. applications, 3 international Patent
Cooperation Treaty, or PCT, applications and 21 foreign applications seeking
protection for selected patents in Japan, Canada and Russia. The issued and
pending patents cover, among other things, aspects of solid-state radiation
detectors including our photodiodes, signal processing, and system
configuration. Our issued patents expire between December 23, 2014 and
April 20, 2021. We have multiple patents covering unique aspects and
improvements for many of our products. We have entered into a royalty-bearing
license for oneU.S. patent with a third party
for exclusive use in nuclear imaging
(subject to certain reservation of rights by the U.S. Government).

In addition to our
solid-state detector and photodiode technology patents, we hold specific
patents for an alternative solid-state

10

method using Cadmium Zinc Telluride that we
previously pursued for use in gamma cameras. While each of our patents applies
to nuclear medicine, many also apply to the construction of area detectors for
other types of medical imagers and imaging methods.

The medical device industry
is characterized by the existence of a large number of patents and frequent
litigation based on allegations of patent infringement. Patent litigation can
involve complex factual and legal questions and its outcome is uncertain. Any
claim relating to infringement of patents that is successfully asserted against
us may require us to pay substantial damages. Even if we were to prevail, any
litigation could be costly and time consuming and would divert the attention of
our management and key personnel from our business operations. Our success will
also depend, in part, on our not infringing patents issued to others, including
our competitors and potential competitors. If our products are found to
infringe the patents of others, our development, manufacture and sale of such
potential products could be severely restricted or prohibited. In addition, our
competitors may independently develop similar technologies. Because of the
importance of our patent portfolio to our business, we may lose market share to
our competitors if we fail to protect our intellectual property rights.

As the number of entrants
into our market increases, the possibility of a patent infringement claim
against us grows. While we make an effort to ensure that our products do not
infringe other parties patents and proprietary rights, our products and methods
may be covered by U.S. patents held by our competitors. In addition, our
competitors may assert that future products we may market infringe their
patents.

Further, a patent
infringement suit brought against us may force us to stop or delay developing,
manufacturing or selling products that are claimed to infringe a third partys
intellectual property, unless that party grants us rights to use its
intellectual property. In such cases, we may be required to obtain licenses to
patents or proprietary rights of others in order to continue to commercialize
our products. However, we may not be able to obtain any licenses required under
any patents or proprietary rights of third parties on acceptable terms, or at
all. Even if we were able to obtain rights to the third partys intellectual
property, these rights may be non-exclusive, thereby giving our competitors
access to the same intellectual property. Ultimately, we may be unable to
commercialize some of our potential products or may have to cease some of our
business operations as a result of patent infringement claims, which could
severely harm our business.

As of December 31, 2004, we
hold trademark registrations in the United States for the following marks: 2020tc Imager®, CardiusSST®, Digirad®, Digirad
Logo®, Digirad Imaging Solutions®, FlexImaging®, and SPECTour®. We have trademark applications pending in the
United States for the following marks: CardiusTM, DigiServSM,
DigiTechSM, SolidiumTM,SeeQuanta TM,
AcqSmart TM, and SPECTpak Plus TM. We have obtained and sought trademark
protection for some of these listed marks in the European Community and Japan.

The healthcare industry, and
thus our business, is highly dependent on a number of factors that may limit
our ability to meet our obligations, a number of which are beyond our
control. These factors include, among
others, (1) third party coverage and reimbursement rules and policies, and (2)
healthcare fraud and abuse enforcement.
Discussed below are certain factors which could have a significant
impact on our future operations and financial condition. It is difficult to predict the effect of
these factors on our operations; however, the factors described below could
have a negative impact on such operations and such effect could be material.

Healthcare providers that
purchase medical devices, such as our products, generally rely on third-party
payors, including the Medicare and Medicaid programs and private payors, such
as indemnity insurers, employer group health insurance programs and managed
care plans, to reimburse all or part of the cost of and utilization of the
products. Products are sold principally
to physicians, hospitals and others that receive reimbursement for the products
and services they provide. As a result,
demand for our products is dependent in part on the coverage and reimbursement
policies of these payors. The manner in which reimbursement is sought and
obtained for any of our products varies based upon the type of payor involved
and the setting in which the product is furnished and utilized by
patients. Third party coverage and
reimbursement for our products and for professional services based on
utilization of our products is subject to extensive federal, state, local and
foreign regulation, and private payor rules and policies. Some of the pertinent
laws, regulations, policies and coverage and reimbursement rules have not been
definitively interpreted by the regulatory authorities or the courts, and their
provisions are open to a variety of interpretations. In addition, these
healthcare laws and their interpretations are subject to change without notice.

Medicare is a federal
program administered by the Centers for Medicare and Medicaid Services, or CMS,
formerly known as HCFA, through fiscal intermediaries and carriers. Available to individuals age 65 or over, and
certain other classes of individuals, the Medicare program provides, among
other things, healthcare benefits that cover, within prescribed limits, the
major costs of most medically necessary care for such individuals, subject to
certain deductibles and co-payments. The
Medicare program has established guidelines for the coverage and reimbursement
of certain equipment, supplies and professional services. In general, in order to be reimbursed by
Medicare, a healthcare item or service furnished to a Medicare beneficiary must
be reasonable and necessary for the diagnosis or treatment of an illness or
injury or to improve the functioning of a malformed body part. The specific coverage and methodology for
determining the amount of Medicare reimbursement for our products and services
varies based upon, among other things, the setting in which a Medicare
beneficiary received healthcare items and services. Any changes in federal legislation,
regulations, Medicare manual provisions, or other rules or policy, or the
interpretation thereof, affecting Medicare coverage and reimbursement relative
to our products could have a material affect on our performance.

Reimbursement to physicians
for nuclear imaging tests is complex and subject to change. In general, physician reimbursement consists
of both a technical component (i.e., the actual performance of the test) and
a professional component (i.e., the interpretation of the test, sometimes
referred to as a read of the test). Physicians may bill for the professional
component if they perform and document a bona fide interpretation. Medicare and
certain other payors permit providers who perform both the technical and
professional components to either bill globally for both components of the
tests, if applicable requirements are met, or to bill for the technical
component and professional component separately. In our lease model, our
physician customers bill globally for both the technical and professional
components of the tests. Assuming they meet certain requirements, including but
not limited to adequate supervision of the non-physician personnel performing
the tests, they may bill and be paid by Medicare according to the Medicare
Physician Fee Schedule.

Under our mixed bill
model, we provided the technical component of nuclear imaging services and
billed either the physician or, if the patient was a Medicare patient, the
Medicare program directly. For those services we billed directly, our Medicare
payment is based on the Medicare Physician Fee Schedule and we billed the
patient for any co-payment. The physician performed and billed the payor for
the professional component for all patients, including the interpretation of
the test. In our lease agreement model, we derive our revenues directly and
only from customer physicians. In our mixed bill model, we derived revenues
from Medicare, as well as direct billings to physicians. We phased out our mixed bill model in
August 2004, and, as of December 31, 2004, have less than $65,000 in accounts
receivable outstanding from Medicare.

Services for which our
customer physicians bill Medicare, and for which we billed Medicare under this mixed
bill model, typically are reimbursed according to the Medicare Physician Fee
Schedule. Medicare revises this Physician Fee Schedule on an annual basis.
Under the Medicare Modernization Act, the Physician Fee Schedule payment rates
for 2004 and 2005 were slightly increased. The payment methodology to physician
practices for drugs were changed, and some payment rates decreased. If the
amounts payable under the Physician Fee Schedule or payments for supplies
decreases under prescribed payment methodologies, our physician customers may
receive less revenue for the tests they perform, which may adversely affect the
amount we can charge physicians who enter into new lease agreements or renew
existing agreements.

We also lease our cameras
and personnel to hospitals. The payment
policies implemented by state and federal reimbursement programs for hospitals
affect demand for our leasing services business by hospitals. Medicare
generally pays for inpatient services under a prospective payment system, or
PPS. Under PPS, hospitals receive a fixed amount for each Medicare patient
discharge for inpatient services. Each discharge is classified into one of many
diagnosis-related groups corresponding to the patients condition. The payment
amount assigned to each diagnosis-related group reimburses the hospital for
inpatient operating costs, regardless of the services actually provided.
Hospital capital-related costs, including investments in depreciable equipment,
also is paid under a PPS methodology. Medicare does not separately reimburse
hospitals for services performed using our cameras, because payment for this
service is included in the diagnosis-related group payment amount. Many state
Medicaid programs and private payors have adopted comparable payment policies.

Medicare pays for hospital
outpatient services under the outpatient prospective payment system. Under this
system, services and items furnished in hospital outpatient departments are
reimbursed using a pre-determined amount for each ambulatory payment
classification, which groups together similar services comparable both
clinically and with respect to the use of resources. Certain items and services
are paid based on a fee schedule, and hospitals are reimbursed additional
amounts for certain drugs, biologics and new technologies. Under the Medicare
Modernization Act, revisions were made to the payment methodology for
radiopharmaceuticals and drugs used with our cameras, and additional changes
can be expected. We cannot predict the
extent to which the payment

12

methodology changes will have an impact on
our revenue or business, if any.

We believe we have
structured our DIS contracts so that physicians and hospitals are able to bill
in this manner if they comply with the terms of the contracts and the
requirements of applicable radioactive materials laws are met. However, if any
of our customer physicians are deemed not to meet these conditions, payment to
the affected physicians could be reduced, denied or recouped. If the failure to
comply is deemed to be knowing and/or willful, as defined in federal
statutes, the government could seek to impose fines or penalties under the
False Claims Act and other statutes. This may require us to restructure our
agreements with these physicians and/or respond to any resultant claims by
physicians or the government.

We currently sell cameras to
physicians, physician groups or medical groups. Physicians who perform or
supervise nuclear imaging procedures in their offices are reimbursed by
Medicare under the Physician Fee Schedule, assuming applicable requirements are
met. Physicians may also be reimbursed for independently covered supplies they
use in performing these procedures. The payment policies implemented by state
and federal reimbursement programs for physicians affect demand for our
cameras. We also sell cameras to hospitals. The payment policies implemented by
state and federal reimbursement programs for hospitals affect demand for our
cameras. The same rules and regulations concerning reimbursement for inpatient
and outpatient services that apply to our hospital leases also apply to our
sales of cameras to hospitals.

The Medicaid program is a
cooperative federal/state program that provides medical assistance benefits to
qualifying low income and medically needy persons. State participation in Medicaid is optional and
each state is given discretion in developing and administering its own Medicaid
program, subject to certain federal requirements pertaining to payment levels,
eligibility criteria and minimum categories of services. The coverage, method
and level of reimbursement for physician and hospital services using our
products and services varies from state to state and is subject to each states
budget restraints.

The scope of coverage and
payment policies varies among third-party private payors. Many non-governmental third-party private
payors, including indemnity insurers, employer group health insurance programs
and managed care payors, such as health maintenance organizations, preferred
provider organizations, and certain other insurers, often impose varying
requirements and limitations on the ability of diagnostic test providers such
as our physician and hospital customers, to receive payment directly for the
services they provide. For example, some payors will not reimburse a provider
of nuclear imaging services for the tests it performs unless the provider has a
contract with the payor, and in many instances such payors will not enter into
such contracts. On the other hand, most of these payors currently will provide
reimbursement on a global basis to a physician who has a contract with the
payor and who supervises or performs the test and provides the professional
interpretation. Such payor requirements and limitations restrict the types of
business models we can successfully utilize for patients covered by these
payors, but currently do not preclude us from successfully implementing our
lease models. However, it is possible that some of these payors will impose new
requirements or limitations in the future that could adversely affect us and
require us to develop new models.
Furthermore, many such payors are investigating or implementing methods
for reducing healthcare costs, such as the establishment of capitated or
prospective payment systems,that may affect our business.

We are aware of a third
party payor in a geographic location currently served by us that issued
guidelines prohibiting our physician customers from obtaining reimbursement for
procedures they perform unless they own or lease our cameras on a full time
basis. This payor is also requiring physicians to obtain accreditation or
certification by either the Intersocietal Commission for the Accreditation of
Nuclear Medicine Laboratories or the American College of Radiology, and to meet
certain other privileging standards, to obtain reimbursement for nuclear
imaging procedures. We cannot assure you
that these guidelines will be changed, or that they will not be adopted in
other jurisdictions or by other third party payors, including Medicaid and
private insurers.

In addition to the foregoing
third party payor coverage and reimbursement factors, other aspects of the
health industry regulation may negatively affect us. We are subject to various federal and state laws and regulations pertaining
to healthcare fraud and abuse, including among others, anti-kickback laws,
false claims laws, and physician self-referral laws, all of which are referred
to as fraud and abuse laws. Violations of these fraud and abuse laws are
punishable by criminal, civil and/or administrative sanctions, including, in
some instances, imprisonment and exclusion from participation in federal and
state healthcare programs, including Medicare and Medicaid. Federal and
state governmental agencies are continuing heightened enforcement efforts in
the healthcare industry, and whistleblower cases brought under certain of these
laws are becoming more common in the healthcare industry. Because of
the far-reaching nature of these fraud and abuse laws, there can be no
assurance that the occurrence of one or more violations of these laws

13

would not result in a
material adverse effect on our business, financial condition and results of
operations. We discuss below the fraud and
abuse laws that are most relevant to our business and most frequently cited in
enforcement actions.

Our
operations are subject to federal and state anti-kickback laws. The
Medicare/Medicaid Anti-Kickback Statute prohibits entities such as us from
knowingly and willingly offering, paying, soliciting or receiving any form of
remuneration (including any kickbacks, bribe or rebate) in return for the
referral of items or services for which payment may be made under a federal
healthcare program, or in return for the recommendation, arrangement, purchase,
lease or order of items or services for which payment may be made under a
federal healthcareprogram.
Violation of the federal anti-kickback law is a felony, punishable by criminal
fines and imprisonment for up to five years or both. In addition, the
Department of Health and Human Services may impose civil penalties and exclude
violators from participation in federal healthcare programs such as Medicare
and Medicaid. Many states have also adopted laws similar to the
Anti-Kickback Statute prohibiting payments
intended to induce referrals of products or services paid by Medicaid or other
nongovernmental third party payors.

Recognizing that the
Anti-Kickback Statute is broad and may technically prohibit many innocuous or
beneficial arrangements that are lawful in businesses outside of the healthcare
industry, the OIG promulgated safe harbor regulations protecting certain
arrangements from prosecution under the Anti-Kickback Statute, provided that
all elements of an applicable safe harbor regulation are met. The failure of a transaction or arrangement
to fit precisely within a safe harbor does not mean that it is illegal per se
or that prosecution will be pursued. However, conduct and business arrangements
that do not fully satisfy each element of an applicable safe harbor may result
in increased scrutiny and potential enforcement by government enforcement
authorities such as the OIG.

In addition, from time to
time, the OIG issues written alerts, bulletins and guidance concerning
particular health industry practices potentially enforceable under the
Anti-Kickback Statute or other fraud and abuse laws. For example, in April 2003, the OIG issued a Special
Advisory Bulletin concerning contractual joint ventures. We believe our
business models, arrangements and operations are in compliance with the
Anti-Kickback Statute; however, no assurance can be given that enforcement
authorities or other third parties could not interpret these laws differently
and assert a contrary position.

The Ethics in Patient
Referral Act of 1989, as amended, and commonly referred to as the Stark Law,
prohibits physician referrals of Medicare or Medicaid patients to an entity for
certain designated health services if the physician or an immediate family
member has an indirect or direct financial relationship with the entity, and no
statutory or regulatory exception applies. Financial relationships include an
ownership interest in, or compensation arrangement with, the entity. It also
prohibits an entity receiving a prohibited referral from billing and collecting
for services rendered pursuant to such referral. Designated health services
under the Stark law include inpatient and outpatient hospital services, radiology
services, magnetic resonance imaging, computerized axial tomography scans,
ultrasound services and outpatient prescription drugs. CMS indicated in a final rule issued in 2001
that nuclear medicine is not included as a designated health services under the
Stark Law. CMS has also indicated that
radiopharmaceuticals and pharmacological stress agents used in nuclear imaging
procedures do not constitute designated health services. However, it is
possible that CMS may change its interpretation in the future to include
nuclear imaging and/or one or both of these supplies as designated health
services under the Stark Law. Should that occur, we believe the financial
relationships we have with our physician customers fall within one or more
exceptions to the Stark Law. However, we cannot rule out the possibility that
the government or other third parties could interpret these laws differently
and assert otherwise. Violations of the
Stark Law may lead to the imposition of substantial penalties and fines, the
exclusion from participation in federal healthcare programs, and claims under
the federal False Claims Act and its whistleblower provisions (as discussed
below).

Several states in which we
operate prohibit physician self-referral arrangements through laws, regulations
and interpretations that cover all patients and are not limited to Medicare and
Medicaid patients. Possible sanctions for violating state physician
self-referral laws vary, but may include loss of license and civil and criminal
sanctions. State laws vary from jurisdiction to jurisdiction and, in a few
states, are more restrictive than the federal Stark Law. We believe that we
have structured our operations to comply with these state physician
self-referral prohibition laws in the jurisdictions in which we operate.
However, we cannot rule out the possibility that the government or other third
parties could interpret these statutes differently and assert otherwise. In
certain states in which we do not yet operate, these laws may add considerable
expense to or limit altogether the types of business models we may successfully
utilize.

The federal False Claims Act
imposes civil and criminal liability on individuals or entities who submit (or
cause the submission of) false or fraudulent claims for payment to the
government. Violations of the federal False Claims Act may result in penalties
equal to three times the damages the government sustained, an assessment of
between $5,000 and $10,000 per claim, civil monetary penalties and exclusion
from participation in federal healthcare programs such as the Medicare and
Medicaid programs.

14

The federal False Claims Act also allows a private
individual to bring a qui tam suit on behalf of the government against an
individual or entity for violations of the False Claims Act. In a qui tam suit, the private plaintiff is
responsible for initiating a lawsuit that may eventually lead to the governments
recovering money of which it was defrauded.
In return for bringing the suit on the governments behalf, the statute
provides that the private plaintiff is entitled to receive up to 30% of the
recovered amount from the litigation proceeds if the litigation is successful
plus reasonable expenses and attorneys fees.
Recently, the number of qui tam suits brought against entities in the
healthcare industry has increased dramatically.

In addition, a number of states have enacted laws
modeled after the False Claims Act that allow those states to recover money
which was fraudulently obtained from the state, and additional states may be
expected to enact similar laws in the future.
Some of these state false claims laws adopt different standards of false
claims liability.

The False Claims Act has been used to assert liability
based on novel theories of liability. We are unable to predict whether we could
be subject to actions under the False Claims Act or similar state laws, or the
impact of such actions. However, the costs of defending claims under the False
Claims Act or similar state laws, as well as sanctions imposed under the Act,
could significantly affect our financial performance.

The Health Insurance Portability and Accountability
Act of 1996 (HIPAA) created, in part, two new federal crimes: Healthcare
Fraud and False Statements Relating to Healthcare Matters. The Healthcare Fraud statute prohibits the
knowing and willful execution of a scheme or artifice to defraud any healthcare
benefit program. A violation of the
statute is a felony and may result in fines and/or imprisonment. The False Statements statute prohibits
knowingly and willfully falsifying, concealing or covering up a material fact
by any trick, scheme or device or making any materially false, fictitious or
fraudulent statement in connection with the delivery of or payment for
healthcare benefits, items or services.
A violation of this statute is a felony and may result in fines and/or
imprisonment.

There exist other state and
federal fraud and abuse laws that may be applicable to our operations. Any investigation, prosecution or sanction
under any state or federal fraud and abuse law could have a materially adverse
effect on us.

The healthcare laws and fraud and abuse laws applicable
to our business are complex and subject to variable interpretations. We
maintain certain compliance, review, education and training and other programs
to further our commitment to high standards of ethical and legal conduct and to
minimize the likelihood that we would engage in conduct or enter into
arrangements in violation of applicable authorities. We implemented a compliance program in 2002
to help ensure that we remain in compliance with these laws. We have
established a compliance committee consisting of senior management and legal
counsel that meets regularly, established a compliance hotline that permits our
personnel to report anonymously any compliance issues that may arise and
instituted other safeguards intended to help prevent any violations of the
applicable fraud and abuse laws and healthcare laws, and to remediate any
situations that could give rise to violations. We also review our transactions
and agreements, both past and present, to help assure they are compliant.

Like most companies with
active and effective compliance programs, we occasionally discover compliance
concerns. For example, in 2004, we discovered certain isolated arrangements
that we entered into in good faith but that upon review by our compliance
personnel, raised some compliance concerns under these laws. In accordance with
our compliance program, we took immediate remedial steps. We cannot assure you
that these remedial steps will insulate us from liability associated with these
isolated arrangements.

Through our compliance
efforts, we constantly strive to structure our business operations and
relationships with our customers to comply with all applicable legal
requirements. However, it is possible that governmental entities or other third
parties could interpret these laws differently and assert non-compliance with
respect to our business operations and relationships including these isolated
arrangements. While there have been no claims asserted against us, if a claim
were asserted and we were not to prevail, possible penalties and sanctions
could have a material effect on our financial statements or our ability to
conduct our operations.

HIPAA also establishes
uniform standards governing the conduct of certain electronic healthcare
transactions and protecting the security and privacy of individually
identifiable health information maintained or transmitted by healthcare
providers, health plans and healthcare clearinghouses. Since April 2003, we
have been required to comply with the standards for privacy of individually
identifiable health information, which restrict our use and disclosure of
certain individually identifiable health information. Since October 2003, we
have also been required to comply with the standards for electronic
transactions, which establish standards for

15

common healthcare transactions, such as
claims information, plan eligibility, payment information and the use of
electronic signatures. We believe that
we are in compliance with these standards. The security standards will require
us to implement certain security measures to safeguard certain electronic
health information. In addition, by
April 21, 2005, and by May 23, 2007, we must adopt unique health
identifiers for use in filing and processing healthcare claims and other
transactions. Our compliance with this
law may entail significant and costly changes for us. If we fail to comply with
these standards, we could be subject to criminal penalties and civil sanctions.

In addition to federal
regulations issued under HIPAA, some states have enacted privacy and security
statutes or regulations that, in some cases, are more stringent than those
issued under HIPAA. In those cases, it may be necessary to modify our
operations and procedures to comply with the more stringent state laws, which
may entail significant and costly changes for us. We believe that we are in
compliance with such state laws and regulations. However, if we fail to comply
with applicable state laws and regulations, we could be subject to additional
sanctions.

Our lease services business
involves administering and furnishing radiopharmaceuticals and pharmacological
stress agents, which are regulated as drugs by state and federal agencies,
including the FDA and state pharmacy boards. These agencies administer laws
governing the manufacturing, sale, distribution, use, administration and
prescribing of drugs, including the federal Food, Drug and Cosmetic Act, state
food and drug laws and state pharmacy acts. Some of our activities may be
deemed by relevant agencies to require permits or licensure under these laws
that we currently do not possess. If any of these agencies deemed our
activities to require such permits or licensure, we would be required to either
obtain such permits or licensure, if possible, or modify the types of business
models we can utilize in the affected jurisdiction(s), and could be subject to
civil, criminal and/or administrative penalties. In either case, we would incur
substantial expense and could encounter substantial operational burdens.

The procurement, use,
transfer and storage of radioactive materials is subject to comprehensive
regulation under state and federal laws. In some states, the federal Nuclear
Regulatory Commission, or NRC, directly regulates such use (NRC States). In
other states, a state regulatory agency performs such regulation under an
agreement with the federal government (Agreement States). In both Agreement and
NRC States, the use of radioactive materials requires licensure and compliance
with comprehensive rules governing such licensure.

Because our DIS business
entails the use of radiopharmaceuticals in performing nuclear medicine tests,
we are required to obtain and maintain licensure under radioactive materials
laws, or RAM laws, and to comply with such laws. The RAM laws require, among
other things, that such materials be used by, or that their use be supervised
by, individuals with specified training, expertise and credentials in the type
of use in question. Such individuals are known as authorized users.

The RAM laws include
specific provisions applicable to the medical use of radioactive materials. For
a business such as ours, the authorized user must be a physician with training
and expertise in the use of radioactive materials for diagnostic purposes. We
have entered into contracts with qualified physicians in each of our regions to
serve as authorized users.

In some states, the
authorized user is required to participate in or oversee the selection of
patients and the ordering of procedures and/or supplies. Some states also
require that an authorized user perform an interpretation of the nuclear
medicine tests. The authorized user need not be present at the customer physicians
site to perform such functions.

Under the RAM laws,
physicians who are not licensed authorized users, but who are supervised by an
authorized user on behalf of a licensed entity, are permitted to use
radioactive materials under the authority of such licensure, if certain
conditions are met. Because our physician customers in our lease services
business are not licensees and in most cases are not qualified to serve as
authorized users, they perform nuclear medicine procedures as supervised
persons. To the extent required by applicable RAM laws, the authorized users
perform some of the functions described above. For example, in states where an
authorized user must perform an interpretation to satisfy RAM licensing laws,
an authorized user does so. The physician customer reimburses the authorized
user for doing so and also performs his or her own interpretation.

We believe that we have
structured our operations so that they comply with applicable RAM laws in the
jurisdictions in which we operate, and that the manner in which we comply with
these laws is also consistent with applicable Medicare requirements. However,
we cannot rule out the possibility that the government or other third parties
could interpret these laws differently and assert otherwise.

Our products are medical
devices subject to extensive regulation by the FDA and other regulatory bodies.
FDA regulations govern, among other things, the following activities that we or
our partners perform and will continue to perform: product design and development, testing,
manufacturing, labeling, and storage; recordkeeping, pre-market clearance or
approval; advertising and promotion; and product sales and distribution.

Unless an exemption applies,
each medical device we wish to commercially distribute in the United States
will require either prior 510(k) clearance or prior pre-market approval from
the FDA. The FDA classifies medical devices into one of three classes, depending
on the degree of risk associated with each medical device and the extent of
control needed to ensure safety and effectiveness. Devices deemed to pose lower
risk are placed in either class I or II, which requires the manufacturer
to submit to the FDA a pre-market notification requesting permission for
commercial distribution. This process is known as 510(k) clearance. Some
low-risk devices are exempted from this requirement. Devices deemed by the FDA
to pose a greater risk, such as life-sustaining, life-supporting or implantable
devices, or a device deemed not substantially equivalent to a previously
cleared 510(k) device or device that was in commercial distribution before May
28, 1976 for which the FDA has not yet called for the submission of a pre-market
approval application, or PMA, are placed in class III. Such a device is commonly referred to as a legally
marketed predicate device. In general,
a class III device cannot be marketed in the United States unless the FDA
approves the device after submission of a PMA.

When we are required to
obtain a 510(k) clearance for a device that we wish to market, we must submit a
pre-market notification to the FDA demonstrating that the device is
substantially equivalent to a legally marketed predicate device By regulation, the FDA is required to
respond to a 510(k) pre-market notification within 90 days of submission
of the notification. As a practical matter, clearance can take significantly
longer. If the FDA determines that the device is not substantially equivalent
to a legally marketed predicate device, the FDA will place the device into
class III.

After a device receives
510(k) clearance, any modification that could significantly affect its safety
or effectiveness or that would constitute a major change in its intended use
will require a new 510(k) clearance. If
the change renders the device not substantially equivalent to a legally
marketed predicate device, a PMA may be required. The FDA requires each device
manufacturer to determine itself whether a modification requires a new
clearance or approval, but the FDA can review any such decision and can
disagree with a manufacturers determination. If the FDA disagrees with a
manufacturers determination that a new clearance or approval is not required
for a particular modification, the FDA can require the manufacturer to cease
marketing and/or recall the modified device until 510(k) clearance or PMA
approval is obtained.

We have made and plan to
continue to make additional product enhancements to our gamma cameras that we
believe do not require new 510(k) clearances.
If the FDA requires us to seek 510(k) clearance or PMA approval for any
modifications to a previously cleared product, we may be required to cease
marketing or recall the modified device until we obtain this clearance or
approval. Also, in these circumstances, we may be subject to significant
regulatory fines or penalties.

A PMA must be submitted if
the device cannot be cleared through the 510(k) process. The PMA process is
much more demanding than the 510(k) pre-market notification process. A PMA must
be supported by extensive data, including, but not limited to, technical
information, preclinical and clinical trial data, manufacturing information,
and labeling, to demonstrate to the FDAs satisfaction the safety and
effectiveness of the device. To date, we
have not been required to, and have not, submitted a PMA with respect to any of
our products.

A clinical trial is almost
always required to support a PMA and is sometimes required for a 510(k)
pre-market notification. For devices presenting a significant risk, clinical
trials require submission of an application for an investigational device
exemption to the FDA. The investigational device exemption application must be
supported by appropriate preclinical data, such as animal and laboratory
testing results, showing that it is safe to test the device in humans and that
the testing protocol is scientifically sound.
Clinical trials for a significant risk device may begin once the
investigational device exemption application is approved by the FDA and the
trial protocol, informed consent, and other trial documentation is approved by
the appropriate institutional review boards for the clinical trial sites. For non-significant risk devices, clinical
trials may begin once the trial protocol, informed consent, and other trial
documentation is approved by the appropriate institutional review boards for
the clinical trial sites. Our clinical
trials must be conducted in accordance with FDA clinical investigation
regulations. Even when clinical trials are conducted in compliance with all FDA
requirements, the results of clinical testing may not be sufficient to obtain
clearance or approval of the product.

After a device is placed on
the market, numerous post-market regulatory requirements apply. These include:

quality system
regulation, which requires manufacturers to follow design, testing, control,
documentation and other quality assurance procedures during the manufacturing
process;

labeling
regulations, which prohibit the promotion of products for uses not cleared or
approved and impose other restrictions on labeling; and

medical device
reporting regulations, which require that manufacturers report to the FDA if
their device may have caused or contributed to a death or serious injury or
malfunctioned in a way that would likely cause or contribute to a death or
serious injury if it were to recur.

Failure to comply with
applicable regulatory requirements can result in enforcement action by the FDA,
which may include: warning letters, fines, injunctions, and civil penalties;
recall or seizure of our products; operating restrictions, partial suspension
or total shutdown of production; refusing our request for 510(k) clearance or
PMA approval of new products; withdrawing 510(k) clearance or PMA approvals
that are already granted; and criminal prosecution.

We are subject to
unannounced inspections by the FDA and the Food and Drug Branch of the
California Department of Health Services, and these inspections may include the
manufacturing facilities of our subcontractors.

International sales of
medical devices are subject to foreign government regulations, which vary
substantially from country to country. The time required to obtain approval by
a foreign country may be longer or shorter than that required for FDA approval,
and the requirements may differ.

The primary regulatory
environment in Europe is that of the European Union, which consists of 15
countries encompassing most of the major countries in Europe. Other countries,
such as Switzerland, have voluntarily adopted laws and regulations that mirror
those of the European Union with respect to medical devices. The European Union
has adopted numerous directives and standards regulating the design,
manufacture, clinical trials, labeling, and adverse event reporting for medical
devices. Devices that comply with the requirements of a relevant directive will
be entitled to bear European Compliance, or CE, conformity marking, indicating
that the device conforms with the essential requirements of the applicable
directives and, accordingly, can be commercially distributed throughout
Europe. The method of assessing
conformity varies depending on the class of the product, but normally involves
a combination of self-assessment by the manufacturer and a third-party
assessment by a notified body. This third-party assessment may consist of an
audit of the manufacturers quality system and specific testing of the
manufacturers product. An assessment by a notified body in one country within
the European Union is required in order for a manufacturer to commercially
distribute the product throughout the European Union. In 2001, we were
certified by TUV Product Service, a notified body, under the European Union
Medical Device Directive allowing the CE conformity marking to be applied.

Our current products are
approved for market release by the FDA. We also received regulatory approval
from the Japanese Ministry of Health in October 2000, which is similar to
our FDA Establishment Registration. In March 2003, we received GOST certification,
the quality and safety certification system administered by the Russian
committee, Gosstandart, to distribute the 2020tc
imager and SPECTour chair in Russia.

As of December 31,
2004, we had a total of 361 employees, of which 163 were employed in clinical
and regulatory, 88 in operations, 48 in general and administrative, 40 in sales
and marketing and 22 in research and development. We had a total of 204
employees in our DIS subsidiary. None of our employees is represented by a
labor union. We have not experienced any work stoppages and consider our
employee relations to be good.

We make available free of
charge on or through our Internet website our annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K and all
amendments to those reports as soon as reasonably practicable after such
material is electronically filed with or furnished to the Securities and
Exchange Commission. Our Internet address is www.digirad.com.

An investment in our common stock involves a high degree of risk. You should carefully consider the risks and
uncertainties described below, together with all other information included in
this annual report, including the consolidated financial statements and the
related notes herein, as well as in our
other public filings, before making any investment decision regarding
our stock. If any of the following risks
actually occurs, our business, financial condition, results of operations and
future prospects would likely be materially and adversely affected. In that event, the market price of our stock
could decline and you could lose all or part of your investment.

The medical device industry,
including the market for imaging systems and services, is highly competitive,
subject to rapid change and significantly affected by new product introductions
and market activities of other industry participants. Our primary competitors
with respect to imaging systems include several large medical device
manufacturers, including Philips Medical Systems, General Electric Healthcare,
Siemens Medical Systems and Toshiba Medical Systems. All of these competitors
offer a full line of imaging cameras for each diagnostic imaging technology,
including x-ray, magnetic resonance imaging, computerized tomography,
ultrasound and nuclear medicine. The existing imaging systems sold by our
competitors have been in use for a longer time than our products and are more
widely recognized and used by physicians and hospitals for nuclear imaging.
Many of our competitors and potential competitors enjoy significant competitive
advantages over us, including:

significantly
greater name recognition and financial, technical, service and marketing
resources;

additional
lines of products and the ability to offer rebates or bundle products to offer
discounts or incentives; and

greater
resources for product development, sales and marketing.

The competitive nature of
the nuclear imaging industry has had an impact on the price of our gamma
cameras. While we anticipate demand for our gamma cameras to continue to increase,
we believe these pricing pressures will continue to impact our gamma camera
product revenue and gross profit.

We are aware of certain
major medical device companies that are attempting to develop solid-state
cameras and we believe these efforts will continue. In addition, we are aware
of a privately-held company, Gamma Medica, which is currently marketing a
solid-state gamma camera for breast imaging. We do not believe that this camera
can be used in a cardiac application. However, we cannot assure you that Gamma
Medica will not attempt to modify its existing camera for use in the cardiac
segment in the future, or develop another gamma camera for cardiac
applications. Because of the size of the potential market, we anticipate that
companies will dedicate significant resources to developing competing products
and services. Current or future competitors may develop technologies and
products, including hybrid technologies, that demonstrate better image quality,
ease of use or mobility than our imaging systems. For example, there are hybrid
modalities commercially available that combine the technologies of positron
emission tomography, or PET, with computed tomography, or CT, as well as others
that combine single photon emission computed tomography, or SPECT, with CT
technology. Our ability to compete
successfully will depend on our ability to develop proprietary products that
reach the market in a timely manner, receive adequate reimbursement and are
less expensive than alternatives available for the same purpose. If we are
unable to compete effectively against our existing and future competitors, our
sales will decline and our business will be harmed.

In providing comprehensive mobile nuclear imaging
solutions, we generally compete against small businesses employing traditional
vacuum tube cameras that must be transported in large vehicles and cannot be
moved in and out of physician offices.
We are also aware of a number of physicians who use Digirad cameras in
small mobile imaging businesses.

Physicians and hospitals
purchasing and using our products rely on adequate third-party payor coverage
and reimbursement to maintain their operations. Changes in domestic and
international legislation, regulation or coverage and reimbursement policies of
third-party payors may adversely affect the demand for our existing and future
products and services and may limit our ability to

19

market and sell our products and services on
a profitable basis. For example, on December 8, 2003, President Bush
signed into law the Medicare Prescription Drug, Improvement and Modernization
Act of 2003, or the Medicare Modernization Act, which contains a wide variety
of changes that impact Medicare reimbursement to physicians and hospitals. We
cannot predict what additional changes will be made to such legislation,
regulation, or coverage and reimbursement policies, but we believe that future
coverage and reimbursement may be subject to increased restrictions both in the
United States and in international markets. Additionally, we cannot be certain
that under prospective payment systems, or established fee schedule payment
formulas, under which healthcare providers may be reimbursed a fixed amount
based on the patients condition or the type of procedure performed, the costs
of our products and services will be justified and incorporated into the
overall payment for the procedure. Third-party payors continue to act to
contain or reduce healthcare costs through various means, including the
movement to managed care systems where healthcare providers contract to provide
comprehensive healthcare for a fixed fee per patient. We are aware of a third
party payor in a geographic location currently served by us that issued
guidelines that prohibit our physician customers from obtaining reimbursement
for procedures they perform unless they own or lease our cameras on a full time
basis. This payor is also requiring
physicians to be accredited by either the Intersocietal Commission for the
Accreditation of Nuclear Medicine Laboratories or by the American College of
Radiology, and to meet certain other privileging standards, in order to obtain
reimbursement for nuclear imaging procedures.
We cannot assure you that these guidelines will be changed, or that they
will not be adopted or by other third party payors, including Medicaid and
private insurers. These continued
efforts may result in third-party payors refusing to reimburse patients or
healthcare providers for our imaging services or allowing only specific providers
to provide imaging services. As a result, sales of our gamma cameras would
suffer and we may receive pressure from our customers to terminate or otherwise
modify the lease arrangements for our DIS services. Under such circumstances,
our business, financial condition and results of operations could be materially
adversely affected.

Our nuclear imaging system
and DIS services may become obsolete or unmarketable if other products or
services utilizing new technologies or the development of hybrid imaging
modalities, such as those combining PET and CT or SPECT and CT, or any other
imaging modality, are introduced by our competitors or new industry standards
emerge. We cannot assure you that we will be able to successfully develop or
market new products and services, or enhancements to our existing products, or
that our future products and enhancements will be accepted by our current or
potential customers or the third-party payors who financially support many of
the procedures performed with our products. Any of these circumstances may
cause us to lose customers, disrupt our business operations and harm our product
sales and services. To be successful, we will need to enhance our products or
services and to design, develop and market new products that successfully
respond to competitive developments, all of which efforts may be expensive and
time consuming.

The success of any new
product offering or enhancement to an existing product will depend on several
factors, including our ability to:

properly
identify and anticipate physician and patient needs;

develop new
products or enhancements in a timely manner;

obtain the
necessary regulatory approvals or clearances for new products or product
enhancements in a timely manner;

provide
adequate training to users of our products;

price our
products competitively;

obtain
appropriate coverage and receive adequate reimbursement notifications and
respond to them in a commercially viable way;

comply with
changing or new regulatory requirements; and

develop an
effective marketing, sales and distribution network.

If we do not develop and
obtain regulatory approvals or clearances for new products, services or product
enhancements in time to meet market demand, or if there is insufficient demand
for these products, services or enhancements, our business, financial condition
and results of operations will likely suffer. In addition, even if our
customers acquire new products, services or product enhancements we may offer,
the revenues from any such products, services or enhancements may not be
sufficient to offset the significant costs associated with offering such
products, services or enhancements to customers. In addition, any announcements
of new products, services or enhancements may cause customers to decline or
cancel their purchasing decisions in anticipation of such products, services or
enhancements.

We expect that substantially
all of our revenue in the foreseeable future will be derived from sales of our
products in the nuclear imaging market and our leasing services offered through
DIS. Our solid-state gamma cameras and DIS services represent a new approach in
the nuclear imaging market. We began full commercial release of our imaging
systems in March 2000 and established DIS in September 2000. Because
of the recent commercial introduction of our nuclear imaging systems, we have
limited product and brand recognition and our imaging systems have been used by
a limited number of physicians and hospitals. Physicians and hospitals may
generally be slow to adopt our products and leasing services for a number of
reasons, including:

perceived
liability risks generally associated with the use of new technologies for
nuclear imaging;

availability of
reimbursement from health care payors for procedures using our system;

lack of
experience with our products and services;

costs
associated with the purchase or lease of our products and services;

the presence of
competing products sold by companies with longer operating histories, more
recognizable names and more established distribution networks;

the
introduction or existence of competing products and services or technologies
that may be more effective, easier to use or that produce better images;

our ability to retain our
current customers;

the creation of competing
mobile imaging businesses by physicians and others who may purchase mobile
cameras that are part of our existing installed base of over 400 cameras; and

physician and
hospital perceptions of our imaging systems as compared to those of
competitors.

Our success in the nuclear
imaging market depends on whether physicians and hospitals view our imaging
systems and DIS services as effective and economically beneficial and as
attractive alternatives to vacuum tube imaging systems. We also believe that
recommendations and support of our products and services by influential
physicians and other health care providers are essential for market acceptance
and adoption. We cannot assure you that physicians or hospitals will adopt or
accept our imaging systems or DIS services. If physicians and hospitals do not
adopt our imaging systems or DIS services, our operating results and business
will be harmed.

We plan to grow our DIS
business by expanding into several new states, adding new hub locations in
states in which we currently operate and increasing hub utilization by adding
physician customers and routes. As we undertake this expansion, we have hired
and will need to continue to hire, train and retain qualified personnel. We
cannot assure you that physicians or hospitals in these new markets will accept
our imaging products or services. Our expansion into additional domestic
markets is subject to inherent risk, including the burden of complying with
applicable state regulations, including but not limited to regulations
concerning the use, storage, handling and disposal of radioactive materials,
the difficulties in obtaining the necessary radioactive licensures and
difficulties in staffing and managing operations. Furthermore, physician
self-referral laws currently in effect in the State of New York may not allow
the conduct of our DIS business as it is currently structured and we may find
the laws of other states in which we do not currently operate to require us to
change the structure of our DIS business to operate in such states.

Our current product and
leasing service offerings consist primarily of our line of gamma cameras,
including our Cardius-1, Cardius-2, Cardius-3, 2020tc Imager and SPECTpak PLUS camera systems, each of which is
designed for use in the nuclear imaging market segment and all of which utilize
the same solid-state technology. In addition, we offer a mobile imaging leasing
service through DIS, which includes an imaging system, certified personnel,
required licensure and other support for nuclear imaging procedures. As such,
our line of products and services is not as diversified as those of some of our
competitors. Consequently, if sales of our products or leasing services decline
precipitously, our business would be seriously harmed, and it would likely be
difficult for

21

us to recover because we do not have the
breadth of products or services that would enable us to sustain our business
while seeking to develop new types of products or services or other markets for
our existing products and services. In addition, because our technical know-how
and intellectual property have limited applications, we may be unable to
leverage our technical know-how and intellectual property to diversify our
products and services or to develop other products or sources of revenue
outside of the nuclear imaging market.

Our gamma cameras have only
recently been introduced into the marketplace. Most of our cameras currently in
use are less than four years old. We have experienced some reliability issues
with a prior version of our detector heads. In July 2003, we began selling most
of our gamma cameras with a new version of our detector heads which has shown
increased reliability, although other reliability issues remain. In addition,
as the period of use of our cameras increases, other significant defects may
occur. If significant defects do arise with our gamma cameras, our reputation
among physicians and hospitals could be damaged.

Additionally, physicians
rely on our DIS services to provide nuclear imaging procedures to their
patients on the dates and at the times they have leased. Many factors could
prevent us from delivering our DIS services on a timely basis, including
equipment failures, weather and the availability of staffing, transportation
and necessary supplies. If we are unable to provide physicians or hospitals our
DIS services in a timely and effective manner, our reputation among physicians
and hospitals could be damaged.

The performance and
reliability of our products and services are critical to our reputation and to
our ability to achieve market acceptance of those products and services.
Widespread or other failures of our cameras and other products to consistently
meet the expectations of purchasers or customers that use our DIS services
could adversely affect our reputation, our ability to provide our DIS services,
our relations with current customers and our business operations. Such failures
could also reduce the attractiveness of our products and services to potential
customers. Equipment failures could result from any number of causes, including
equipment aging, ordinary wear and tear due to regular transportation and relocation,
failure to perform routine maintenance and latent hardware or software defects
of which we are unaware. Such failures, whether actual or perceived, could
adversely affect our business even if we correct the underlying problems.

There are numerous risks
associated with any leasing arrangement, including the possibility that
physicians may fail to make the required payments under the terms and
provisions of their lease commitments. Our DIS business is also affected by the
ability of physicians to pay us, which in turn may be affected by general
economic and business conditions and the availability of reimbursement for the
physicians. In addition, some DIS customers may decide to purchase their own
cameras, made by us or by our competitors, rather than to continue to use the
DIS leasing service which would cause us to lose business. Such circumstances could adversely affect our
business and financial condition.

Our success is dependent on
the efforts of our key technical, sales and managerial personnel and our
ability to retain them. The loss of any one or more of these individuals could
place a significant strain on our remaining management team and we may have
difficulty replacing any of these individuals. Furthermore, our future growth
will depend in part upon our ability to identify, hire and retain additional
key personnel, including nuclear imaging technologists, certified cardiographic
technicians, nurses, radiation safety officers, engineers, management, sales
personnel and other highly skilled personnel. Hiring qualified management and
technical personnel will be difficult due to the limited number of qualified
candidates. Competition for these types of employees, particularly nuclear
imaging technologists and engineers, is intense in the medical imaging field.
Given the competition for such qualified personnel, we cannot assure you that
we will be able to continue to attract, hire and retain the personnel necessary
to maintain and develop our business. Failure to attract, hire and retain key personnel
could have an adverse effect on our business, financial condition and results
of operations. We do not have any employment agreements with, or key person
insurance on, any of our employees.

We rely on a limited number
of third parties to manufacture and supply certain of the key components of our
products. While many of the components used in our products are available from
multiple sources, we obtain some components from single sources. For example,
key components of the detector heads and the acquisition and control software
utilized in our gamma cameras are manufactured or supplied by a single source.
To be successful, our contract manufacturers and suppliers must provide us with
the components of our systems in requisite quantities, in compliance with
regulatory requirements, in accordance with agreed-upon

22

specifications, at acceptable cost and on a
timely basis. Segami Corporation, or Segami, has developed image processing
software for our camera under a non-exclusive license agreement. In the event
that Segami attempts to terminate the license agreement, refuses to extend the
term of the license or seeks to impose unreasonable pricing or terms, we would
have to find an alternative software system to use in our gamma camera. Our
reliance on these outside suppliers subjects us to a number of risks that could
harm our business, including:

suppliers may
make errors in manufacturing components that could adversely affect the
efficacy or safety of our products or cause delays in shipment of our products;

we may not be
able to obtain adequate supply in a timely manner or on commercially reasonable
terms;

we may have
difficulty locating and qualifying alternative suppliers for our components;

once we
identify alternative suppliers, we could experience significant delays in
production due to the need to evaluate and test the products delivered by
alternative suppliers and to obtain regulatory qualification for them;

we are not a
major customer of many of our suppliers, and these suppliers may therefore give
other customers needs higher priority than ours;

we use some
suppliers that are small, privately-held companies, and these suppliers could
encounter financial or other difficulties that could cause them to modify or
discontinue their operations at any time;

our suppliers
manufacture products for a range of customers, and fluctuations in demand for
the products those suppliers manufacture for others may affect their ability to
deliver components to us in a timely manner; and

our suppliers
may encounter financial hardships unrelated to our demand for components, which
could inhibit their ability to fulfill our orders and meet our requirements.

Any interruption or delay in
the supply of components or materials, or our inability to obtain components or
materials from alternate sources at acceptable prices in a timely manner, could
impair our ability to meet the demand of our customers and cause them to cancel
orders or switch to competitive procedures. These events could harm our
business and operating results.

We began commercial
production and shipped our first imaging products in 2000, and therefore have
limited experience in marketing, selling and distributing our products and
services. Additionally, while we have a
direct sales team focused on domestic marketing, sales and distribution, we
also use four independent distributors in the United States and two
independent, international sales distributors to market, sell and distribute
our products and services. As a result, we are dependent in part upon the
marketing, sales and distribution efforts of our third-party distributors. To
date, one of our domestic third-party distributors is permitted to market, sell
and distribute competing imaging services and products. Additionally, one of
our domestic third-party distributors is generally permitted to market, sell
and distribute competing imaging products that are used or refurbished and meet
specified age requirements. Our international distributor is prohibited from
promoting or distributing any other gamma camera product, but is not prohibited
from offering competing services.

Our future revenue growth
will depend in large part on our success in maintaining and expanding our
marketing, sales and distribution channels, which will likely be an expensive
and time-consuming process. We are highly dependent upon the efforts of our
sales force and third-party distributors to increase our revenue. We face
intense competition for qualified sales employees and may be unable to hire,
train, manage and retain such personnel, which could adversely affect our
ability to maintain and expand our marketing, sales and distribution network,
which would negatively affect our ability to compete effectively as a
distributor of nuclear imaging devices. Additionally, even if we are able to
expand our sales force and enter into agreements with additional third-party
distributors on commercially reasonable terms, they may not commit the
necessary resources to effectively market, sell and distribute our products and
services domestically and internationally. If we are unable to maintain and
expand our direct and third-party marketing, sales and distribution networks,
we may be unable to sell enough of our products and imaging services for our
business to be profitable and our financial condition and results of operations
will likely suffer accordingly.

Our success depends on our
ability to continually enhance and broaden our product and service offerings in
response to changing customer demands, competitive pressures and technologies.
While we have no current plans or commitments regarding any acquisitions of new
or complementary businesses, products or technologies, we may in the future
choose to pursue such acquisitions instead of developing those businesses,
products or technologies ourselves. We cannot assure you, however, that we
would be able to successfully complete any acquisition we choose to pursue, or
that we would be able to successfully integrate any acquired business, product
or technology into our company in a cost-effective and non-disruptive manner.
Furthermore, there is no certainty that we would be able to attract, hire or
retain key employees associated with any acquired businesses, products or
technologies.

Integrating any acquired
businesses, products or technologies could be expensive and time consuming,
disrupt our ongoing business and divert the attention and resources of our
management. If we are unable to integrate any acquired businesses, products or
technologies effectively, our business will likely suffer. Additionally, any
amortization of assets or charges resulting from the costs of acquisitions
could harm our business and operating results.

We have sales distributors
for our imaging systems in Russia and Puerto Rico and may expand our
international distribution relationships. If we expand internationally, we will
need to hire, train and retain qualified personnel in countries where language,
cultural or regulatory impediments may exist. We cannot assure you that
distributors, physicians or other involved parties in foreign markets will
accept our nuclear imaging products, services and business practices. Any of
international operations will be subject to inherent risks, including:

costs of
localizing product and service offerings for foreign markets;

difficulties in
staffing and managing foreign operations;

reduced
protection for intellectual property rights in some countries;

difficulties
and delays in enforcing agreements and in collecting receivables through the
legal systems of foreign countries;

changes in
political, regulatory, or economic conditions in a country or region;

our ability to
obtain U.S. export licenses and other required export or import licenses or
approvals;

burdens of
complying with a wide variety of foreign laws, regulations specific to the
delivery of and payment for healthcare services, regulations and licensing
requirements relating to the use, storage, handling and disposal of radioactive
materials, labor practices; and

conforming our
business model to operate under government-run healthcare systems.

Our operations entail risks
relating to product liability claims, product recalls, property damage and
personal injury and death. We currently maintain insurance that we believe is
adequate with respect to the nature of the risks insured against, including
product liability insurance, professional liability insurance, automobile
insurance, property insurance, workers compensation insurance and general
liability insurance. In many cases such insurance is expensive and difficult to
obtain, and no assurance can be given that we will be able to maintain our
current insurance or that we will be able to obtain or maintain comparable or
additional insurance in the future on reasonable terms, if at all.
Additionally, we may be negatively affected by increased costs of insurance,
including workers compensation insurance.

Our manufacturing operations
and executive offices are located at a single facility in Poway, California,
near known fire areas and earthquake fault zones. This facility is located a
short distance from the wildfires that destroyed many homes and businesses in
San Diego County, California in 2003. We have taken precautions to safeguard
our facilities, including insurance and health and safety protocols. However,
any future natural disaster, such as a fire or an earthquake, could cause
substantial delays in our operations, damage to or destroy our manufacturing
equipment or inventory, and cause us to incur additional expenses. A disaster
could significantly harm our business and results of operations. The insurance
we maintain against fires and other natural disasters may not be adequate to
cover our losses in any particular case.

Additionally, electrical
power is vital to our operations and we rely on a continuous power supply to
conduct our business. California has experienced significant electrical power
shortages and price volatility in recent years, and such shortages and price
volatility may occur in the future. In the event of an acute power shortage,
the California system operator has on some occasions implemented, and may in
the future implement, rolling blackouts throughout California. If our energy
costs substantially increase or blackouts interrupt our power supply frequently
or for more than a few days, we may have to reduce or temporarily discontinue
our normal operations. In addition, the cost of our research and development
efforts may increase because of the disruption to our operations. Any such
reduction or disruption of our operations at our facilities could harm our
business.

We use hazardous and
radioactive materials in our research and development and manufacturing
processes, as well as in the provision of our imaging services. We are subject
to federal, state and local regulations governing use, storage, handling and
disposal of these materials and waste products. We are currently licensed to
handle such materials in all states in which we operate, but there can be no
assurances that we will be able to retain those licenses in the future. In
addition, we must become licensed in all states in which we plan to expand.
Obtaining those additional licenses is an expensive and time consuming process,
and in some cases we may not be able to obtain those licenses at all.

Although we believe that our
procedures for use, handling, storing and disposing of these materials comply
with legally prescribed standards, we cannot completely eliminate the risk of
contamination or injury resulting from hazardous materials and we may incur
liability as a result of any such contamination or injury. In the event of an
accident, we could be held liable for damages or penalized with fines, and the
liability could exceed our resources.

We have also incurred and
may continue to incur expenses related to compliance with environmental laws.
Such future expenses or liability could have a significant negative impact on
our business, financial condition and results of operations. Further, we cannot
assure you that the cost of complying with these laws and regulations will not
materially increase in the future.

We are directly, or
indirectly through our clients, subject to extensive regulation by both the
federal government and the states and foreign countries in which we conduct our
business. The laws that directly or indirectly affect our ability to operate
our business include, but are not limited to, the following:

the federal
Medicare and Medicaid Anti-Kickback Law, which prohibits persons from knowingly
and willfully soliciting, offering, receiving or providing remuneration,
directly or indirectly, in cash or in kind, to induce either the referral of an
individual, or furnishing or arranging for a good or service, for which payment
may be made under federal healthcare programs such as the Medicare and Medicaid
Programs;

other Medicare
laws, regulations, rules, manual provisions, and policies that prescribe the
requirements for coverage and payment for services performed by us and our DIS
customers, including the amount of such payment;

the federal
False Claims Act, which imposes civil and criminal liability on individuals and
entities who submit, or cause to be submitted, false or fraudulent claims for
payment to the government;

the federal
Health Insurance Portability and Accountability Act of 1996, or HIPAA, which,
among other things, prohibits executing a scheme to defraud any healthcare
benefit program, including private payors and, further, requires us to

25

comply with standards
regarding the privacy and security of individually identifiable health
information and conduct certain electronic transactions using standardized code
sets. In addition, regulations have been issued under HIPAA that will require
us to comply with additional security regulations by April 2005 and to
adopt unique health identifiers for use in filing and processing healthcare
claims and other transactions by May 2007;

the federal
False Statements Statute, which prohibits knowingly and willfully falsifying,
concealing or covering up a material fact or making any materially false
statement in connection with the delivery of or payment for healthcare
benefits, items or services;

the federal
physician self-referral prohibition, commonly known as the Stark Law, which, in
the absence of a statutory or regulatory exception, prohibits the referral of
Medicare or Medicaid patients by a physician to an entity for the provision of
certain designated healthcare services, if the physician or a member of the
physicians immediate family has a direct or indirect financial relationship,
including an ownership interest in, or a compensation arrangement with, the
entity and also prohibits that entity from submitting a bill to a federal payor
for services rendered pursuant to a prohibited referral;

state laws that
prohibit the practice of medicine by non-physicians and fee-splitting
arrangements between physicians and non-physicians, as well as state law
equivalents to the federal Medicare and Medicaid Anti-Kickback Law and the
Stark Law, which may not be limited to government reimbursed items or services;
and

federal laws,
regulations, rules and policies that permit physicians to bill and receive
payment for certain diagnostic tests under the Medicare Physician Fee Schedule
only if certain conditions are satisfied, including the requirement that the
physician personally perform, or adequately supervise the performance of, the
test using equipment they own or lease, and that prohibit physicians from
marking up the cost of tests they purchase, rather than perform or supervise,
for Medicare patients.

We implemented a compliance
program in 2002 to help assure that we remain in compliance with the above and
other applicable laws. Like most companies with active and effective compliance
programs, we occasionally discover compliance concerns. For example, in 2004 we
discovered certain isolated arrangements that we entered into in good faith but
that, upon review by our compliance personnel, raised some compliance concerns
under these laws. In accordance with our compliance program, we took immediate
remedial steps. We cannot assure you that these remedial steps will insulate us
from liability associated with these isolated arrangements.

If our past or present
operations are found to be in violation of any of the laws, regulations, rules
or policies described above or the other governmental regulations to which we or
our customers are subject, or if the interpretation of the foregoing changes,
we may be subject to civil and criminal penalties, damages, fines, exclusion
from the Medicare and Medicaid programs and the curtailment or restructuring of
our operations. Similarly, if our customers are found non-compliant with
applicable laws, they may be subject to sanctions, which could also have a
negative impact on us. In addition, if we are required to obtain permits or
licensure under these laws that we do not already possess, we may become
subject to substantial additional regulation or incur significant expense. Any
penalties, damages, fines, curtailment or restructuring of our operations would
adversely affect our ability to operate our business and our financial results.
The risk of our being found in violation of these laws is increased by the fact
that many of them have not been fully interpreted by the regulatory authorities
or the courts, and their provisions are open to a variety of interpretations,
and additional legal or regulatory change. Any action against us for violation
of these laws, even if we successfully defend against it, could cause us to
incur significant legal expenses, divert our managements attention from the
operation of our business and damage our reputation.

In both the United States
and certain other foreign jurisdictions, there have been a number of
legislative and regulatory proposals to change the healthcare system in ways
that could impact our ability to sell our products and services profitably. In
the United States, federal and state lawmakers regularly propose and, at times,
enact new legislation establishing significant changes in the healthcare
system. Recently, President Bush signed into law the Medicare Modernization
Act, which contains a wide variety of reforms that impact Medicare
reimbursements to hospitals and physicians including changes to Medicare
payment methodologies for radiopharmaceuticals and other drugs dispensed by
hospital outpatient departments and for drugs dispensed by physician offices.
These changes reduced payment amounts for some of the drugs used in conjunction
with our imaging procedures, although the physician fee schedule payment rates
applicable to nuclear cardiology increased slightly in 2003 and 2004. Downward
changes to Medicare reimbursement rates may adversely impact reimbursement to
customers or potential customers that use or could use our cameras and
services. We cannot predict the full impact that this new legislation will have
nor whether new federal legislation will be enacted in the future. The
potential for adoption of healthcare reform proposals on a state-by-state basis
could require us to develop state-specific marketing and sales approaches. In
addition, we may experience pricing pressures in connection with the sale of
our products and services due to additional legislative proposals or healthcare
reform initiatives. Our results of operations and our business could therefore
be adversely affected by future healthcare reforms.

In order for hospitals to
receive certain payments for their outpatient facilities as hospital outpatient
services, including services that utilize our products, these services must be
furnished in a provider-based organization or facility or be covered services
furnished under arrangement with the hospital. Failure to meet these
requirements may result in reduced payments to the hospitals for their
services. The Medicare program has published and revised rules establishing
criteria for classifying a facility as provider-based or a service as
furnished under arrangement. These rules require an analysis of the facts and
circumstances surrounding the delivery by a hospital of a particular service,
and hospitals that use our products or DIS services in their outpatient
facilities will need to determine if they meet the applicable provider-based
or under arrangement requirements. Hospitals that cannot obtain sufficient
payments for these services may not purchase a camera from us or enter into
arrangements with us for provision of services.

All of the states in which
we operate require that the imaging technicians that operate our cameras be
licensed or certified and such licensing and certification requirements are
subject to change. Obtaining such licenses may take significant time as we
expand into additional states or if the applicable requirements change. Any
lapse in the licensure or certification of our technicians could increase our
costs and adversely affect our operations and financial results. Further, we are
currently enrolled by Medicare contractors, or carriers, as an independent
diagnostic testing facility in nine states where we were operating under our mixed
bill model. We discontinued this model in August 2004; however, continued
enrollment is essential for us to collect remaining amounts we billed directly
to Medicare for the healthcare services that we provided under the mixed bill
model.

In the healthcare industry,
various types of organizations are accredited to facilitate meeting certain Medicare
certification requirements, expedite third-party payment and fulfill state
licensure requirements. Some managed care providers prefer to contract with
accredited organizations. We are aware of a third party payor in a geography in
which we do business that is requiring physicians to obtain certain
accreditations in order to obtain reimbursement for imaging procedures, and to
meet specified privileging standards. We
have obtained certification from the Intersocietal Commission for the
Accreditation of Nuclear Medicine Laboratories for one of our hub locations,
and intend to obtain certifications for additional hub locations. If it becomes necessary for us to obtain any
additional accreditation in the future in order to satisfy the requirements of
third-party payors or regulatory agencies, there can be no assurances that we
will be able to obtain or continuously maintain this accreditation.

U.S. and foreign regulatory
agencies, including the FDA, govern the testing, marketing and registration of
new medical devices or modifications to medical devices, in addition to
regulating manufacturing practices, reporting, labeling and recordkeeping
procedures. The regulatory process makes it longer, harder and more costly to
bring our products to market, and we cannot assure you that any of our future products
will be cleared or approved. All of our planned services, products and
manufacturing activities, as well as the manufacturing activities of
third-party medical device manufacturers who supply components to us, are
subject to these regulations. Generally, we and our third-party manufacturers
are or will be required to:

undergo
rigorous inspections by domestic and international agencies;

27

obtain the
prior clearance or approval of those agencies before we can market and sell our
medical device products; and

satisfy content
and format requirements for all of our sales and promotional materials.

Compliance with the
regulations of those agencies may delay or prevent us from introducing new or
improved products, which could in turn affect our ability to achieve or
maintain profitability. We may be subject to sanctions, including Warning
Letters, monetary fines and criminal penalties, the temporary or permanent
suspension of operations, product recalls and marketing restrictions, if we
fail to comply with the laws and regulations applicable to our business. Our
third-party component manufacturers may also be subject to the same sanctions
and, as a result, may be unable to supply components for our products. Any
failure to retain governmental approvals that we currently hold or obtain
additional similar approvals could prevent us from successfully marketing our
products and technology and could harm our operating results. Furthermore,
changes in the applicable governmental regulations could prevent further
commercialization of our products and technologies and could harm our business.

Even if regulatory approval
or clearance of a product is granted, regulatory agencies could impose
limitations on uses for which the product may be labeled and promoted. Further,
for a marketed product, its manufacturer and manufacturing facilities are
subject to periodic review and inspection. Later discovery of problems with a
product, manufacturer or facility may result in restrictions on the product,
manufacturer or facility, including withdrawal of the product from the market
or other enforcement actions.

We are subject to medical
device reporting regulations that require us to report to the FDA or similar
governmental bodies in other countries if our products cause or contribute to a
death or serious injury or malfunction in a way that would be reasonably likely
to contribute to death or serious injury if the malfunction were to recur. In
addition, the FDA and similar governmental bodies in other countries have the
authority to require the recall of our products in the event of material
deficiencies or defects in design or manufacture that could cause adverse
health consequences. A government mandated or voluntary recall by us could
occur as a result of component failures, manufacturing errors or design
defects, including defects in labeling. Any recall would divert management
attention and financial resources and harm our reputation with customers. A
recall involving our product could harm the reputation of the product and our
company and would be particularly harmful to our business and financial
results.

Our products are subject to
rigorous regulation by the FDA, and numerous other federal, state and foreign
governmental authorities. In the U.S., the FDA regulates virtually all aspects
of a medical devices testing, manufacture, safety, labeling, storage,
recordkeeping, reporting, promotion and distribution. Our failure to comply
with those regulations could lead to the imposition of administrative or
judicial sanctions, including Warning Letters, injunctions, suspensions or the
loss of regulatory clearances or approvals, product recalls, termination of
distribution, product seizures, or injunctions.
In the most egregious cases, criminal sanctions or closure of our
manufacturing facilities are possible. The process of obtaining regulatory
clearances or approvals to market a medical device, particularly from the FDA,
can be costly and time consuming, and there can be no assurance that such
clearances or approvals will be granted on a timely basis, if at all. In
particular, unless exempt, the FDA permits commercial distribution of a new
medical device only after the device has received 510(k) clearance or is the
subject of an approved PMA. The FDA will clear marketing of a medical device
through the 510(k) process if it is demonstrated that the new product is
substantially equivalent to a legally marketed predicate device. The PMA approval process is more costly,
lengthy and uncertain than the 510(k) clearance process, and must be supported
by extensive data, including data from preclinical studies and human clinical
trials. Because we cannot assure you that any new products we develop, or any
product enhancements, will be subject to the generally shorter 510(k) clearance
process, significant delays in the introduction of any new products or product
enhancements may occur. While we have not been required to obtain PMA approval
for any of our products, there is no assurance that the FDA will not require a
new product or product enhancement to go through the more lengthy, burdensome,
and expensive PMA approval process. Further, pursuant to FDA regulations, we
can only market our products for cleared or approved uses. If our products are
used for purposes other than those cleared or approved by the FDA, the FDA
could object to such off-label uses.

Our manufacturing processes
and those of our third-party manufacturers are required to comply with the FDAs
Quality System Regulation, which covers the design, testing, production
processes, controls, quality assurance, labeling, packaging, storage and
shipping of our devices. In addition, we must engage in extensive recordkeeping
and reporting and must make available our manufacturing facility and records
for periodic unscheduled inspections by federal, state and foreign agencies,
including the FDA. Our failure or our third-party manufacturers failure to
pass a Quality System Regulation inspection or to comply with these and other
applicable regulatory requirements could result in disruption of our operations
and manufacturing delays, and a failure to take

28

adequate corrective action could result in,
among other things, Warning Letter(s), withdrawal of our medical device
clearances, seizure or recall of our devices, or other civil or criminal
enforcement actions.

Foreign governmental
authorities that regulate the manufacture and sale of medical devices have
become increasingly stringent and, to the extent we now or in the future market
and sell our products in foreign countries, we may be subject to rigorous
regulation by those foreign governmental authorities. In such circumstances, we
would rely significantly on our foreign independent distributors to comply with
the varying regulations, and any failures on their part could result in
restrictions on the sale of our products in foreign countries.

Any modification to a
510(k)-cleared device that could significantly affect its safety or
effectiveness, or that would constitute a major change in its intended
use, requires a new 510(k) clearance or,
possibly, approval of a PMA. The FDA requires every manufacturer to make this
determination in the first instance, but the FDA may review any manufacturers
decision. The FDA may not agree with our decisions regarding whether new
clearances or approvals are necessary. If the FDA requires us to seek 510(k)
clearance or PMA approval for modification of a previously cleared product for
which we have concluded that no clearances or approvals are necessary, we may
be required to cease marketing or to recall the modified product until we
obtain clearance or approval, and we may be subject to significant regulatory
fines or penalties. Further, our products could be subject to recall if the FDA
determines, for any reason, that our products are not safe or effective. Any recall
or FDA requirement that we seek additional approvals or clearances could result
in delays, fines, costs associated with modification of a product, loss of
revenue and potential operating restrictions imposed by the FDA.

For services we provided
until August 2004 under our mixed bill model, we submitted claims directly to
and received payments directly from the Medicare program. Therefore, we remain
subject to extensive government regulation, including requirements for
maintaining certain documentation to support our claims. Government agencies
and Medicare contractors also may conduct inspections or surveys of our
facilities, payment reviews and other audits of our claims and operations. We cannot assure you that such scrutiny will
not result in material delays in payment, as well as material recoupments or
denials, which could reduce our revenue or profits. Our DIS customers also submit claims to
Medicare and other third-party payors, are subject to the same types of
regulation and scrutiny and may experience the same types of problems. This could adversely affect our ability to
market our leases and services and to maintain existing contracts.

the ability of
our suppliers to timely provide us with an adequate supply of necessary
components;

timing and
magnitude of our expenditures;

our ability to
reduce our expenses quickly enough to respond to any declines in revenue;

regulatory
approvals and legislative changes affecting the products we may offer or those
of our competitors;

29

the effect of
competing technological and market developments;

our addition or
termination of research programs or funding support;

levels of
third-party reimbursement for our products and services;

interruption in
the manufacturing or distribution of our products and services; and

changes in our
ability to obtain FDA approval or clearance for our products.

Furthermore, we have
experienced seasonality in the leasing services offered by DIS. While our
physicians are obligated to pay us for all lease days to which they have
committed, our contracts permit some flexibility in scheduling when services
are to be performed. This accounts for some of the seasonality of our DIS
revenues. For example, our daily services have typically declined from our
second fiscal quarter to our third fiscal quarter due to summer holidays and
vacation schedules. We have also experienced declining daily services in
December due to holidays and in our first quarter due to weather conditions in
certain parts of the United States. We cannot predict with certainty the degree
to which seasonal circumstances such as the summer slowdown, winter holiday
variations and weather conditions may make our revenue unpredictable or lead to
fluctuations in our quarterly operating results in the future.

In addition, due to the way
that customers in our target markets acquire our products, a large percentage
of our orders of gamma cameras is booked during the last month of each
quarterly accounting period. As such, a delivery delay of only a few days may
significantly impact our quarter-to-quarter comparisons.

For these reasons, we
believe that quarterly sales and operating results may vary significantly in
the future and that period-to-period comparisons of our results of operations
are not necessarily meaningful and should not be relied upon as indicators of
future performance. We cannot assure you that our sales will increase or be
sustained in future periods. Accordingly, we may experience significant,
unanticipated quarterly losses. Because of these and other factors, our
operating results in one or more future quarters may fail to meet the
expectations of securities analysts or investors, which could cause our stock
price to decline significantly.

We have incurred significant
cumulative net losses since our inception in November 1985 and as of December
31, 2004, we had an accumulated deficit of $80.1million.
We expect to incur increased operating expenses in the near term as we, among
other things:

expand our
manufacturing operations and DIS business;

increase
marketing, sales and distribution of our current products; and

conduct
research and development to develop next-generation products and to enhance our
existing products.

As a result of these
activities, we may not be able to maintain profitability. If our revenue grows
more slowly than anticipated, or if our operating expenses exceed our
expectations, our ability to achieve our development and expansion goals would
be adversely affected.

We currently have a small
number of customers, whom we typically bill after the delivery of our products
and imaging services. If orders for our gamma cameras were to be cancelled, or
our leasing service customers stopped using us or do not renew their lease
agreements with us, or decide to purchase their own camera, our business would
be adversely affected. Furthermore, in view of our small customer base, our
failure to gain additional customers, the loss of any current customers or a
significant reduction in the level of leasing services provided to any one
customer could disrupt our business, harm our reputation and adversely affect
our sales.

Our sales efforts for our
gamma cameras are dependent on the capital expenditures budgets of the
physicians and hospitals to which we market. Often physicians and hospitals
require a significant amount of lead time to plan for a major acquisition such
as the purchase of our imaging systems. We may spend substantial time, effort
and expense long before we actually consummate an order of our cameras and with
no assurance that we will ultimately be successful in achieving any such
orders. As a result, we may experience

30

significant fluctuations in our revenues.
Furthermore, evaluating and predicting our future sales and operating
performance is difficult and may not be as accurate as it could be if we had
shorter sales cycles.

Although we believe that our
current cash and cash equivalents will be sufficient to meet our projected
operating requirements for the foreseeable future, our capital requirements
will depend on many factors, including:

the number and
timing of acquisitions and other strategic transactions; and

the costs
associated with our expansion, if any.

As a result of these
factors, we may need to raise additional funds, and we cannot be certain that
such funds will be available to us on acceptable terms, if at all. Furthermore,
if we issue equity or debt securities to raise additional funds, our existing
stockholders may experience dilution and the new equity or debt securities may
have rights, preferences and privileges senior to those of our existing
stockholders. In addition, if we raise additional funds through collaboration,
licensing or other similar arrangements, it may be necessary to relinquish
potentially valuable rights to our future products or proprietary technologies,
or grant licenses on terms that are not favorable to us. If we cannot raise funds
on acceptable terms, we may not be able to expand our operations, develop new
products, take advantage of future opportunities or respond to competitive
pressures or unanticipated customer requirements.

Our success depends
significantly on our ability to protect our proprietary rights to the
technologies used in our products. We rely on patent protection, as well as a
combination of copyright, trade secret and trademark laws, and nondisclosure,
confidentiality and other contractual restrictions to protect our proprietary
technology. However, these legal means afford only limited protection and may
not adequately protect our rights or permit us to gain or keep any competitive
advantage. Our pending U.S. and foreign patent applications, which include
claims to material aspects of our products and procedures that are not
currently protected by issued patents, may not issue as patents in a form that
will be advantageous to us. Any patents we have obtained or do obtain may be
challenged by re-examination or otherwise invalidated or eventually found
unenforceable. Both the patent application process and the process of managing
patent disputes can be time consuming and expensive. Competitors may attempt to
challenge or invalidate our patents, or may be able to design alternative
techniques or devices that avoid infringement of our patents, or develop
products with functionalities that are comparable to ours. Although we have
taken steps to protect our intellectual property and proprietary technology,
including entering into confidentiality agreements and intellectual property
assignment agreements with our employees, consultants, advisors and corporate
partners, such agreements may not be enforceable or may not provide meaningful
protection for our trade secrets or other proprietary information in the event
of unauthorized use or disclosure or other breaches of the agreements.
Furthermore, the laws of some foreign countries may not protect our
intellectual property rights to the same extent as do the laws of the United
States.

In the event a competitor
infringes upon our patent or other intellectual property rights, litigation to
enforce our intellectual property rights or to defend our patents against
challenge, even if successful, could be expensive and time consuming and could
require significant time and attention from our management. We may not have
sufficient resources to enforce our intellectual property rights or to defend
our patents against challenges from others.

The medical device industry
is characterized by extensive litigation and administrative proceedings over
patent and other intellectual property rights. Whether a product infringes a
patent involves complex legal and factual issues, the determination of which is
often uncertain. Our competitors may assert that our products, their components
or the methods we employ in the use of our products are covered by U.S. or
foreign patents held by them. In addition, they may claim that their patents
have priority over ours because their patents were filed or invented earlier.
Because patent applications can take many years to issue, there may be
applications now pending of which we are unaware, which may later result in
issued patents that our products may infringe. There could also be existing
patents that one or more components of our products may be infringing of which
we are unaware. As the number of participants in our industry increases, the
possibility of patent infringement claims against us also increases.

Any litigation or claims
against us may cause us to incur substantial costs, could place a significant
strain on our financial resources, divert the attention of our management from
our core business and harm our reputation. If the relevant patents were upheld
as valid and enforceable and we were found to be inadvertently infringing, we could
be required to pay substantial damages and/or royalties and could be prevented
from selling our products unless we could obtain a license or were able to
redesign our system to avoid infringement. Any such license may not be
available on reasonable terms, if at all. If we fail to obtain any required
licenses or make any necessary changes to our products or technologies, we may
be unable to commercialize one or more of our products.

The sale and support of our
products entails the risk of product liability or warranty claims, such as
those based on claims that the failure of one of our products resulted in a
misdiagnosis, personal injury or death, among other issues. The medical device
industry has been subject to significant products liability litigation. We may
incur significant liability in the event of any such litigation, regardless of
the merit of the action. Although we maintain product liability insurance, we
cannot be sure that this coverage is adequate or that it will continue to be
available on acceptable terms, if at all. We also may face warranty exposure,
which could adversely affect our operating results. Any unforeseen warranty
exposure or insufficient insurance could harm our business, financial condition
and results of operations. Finally, even a meritless or unsuccessful product
liability claim could harm our reputation in the industry, lead to significant
legal fees and could result in the diversion of managements attention from
managing our business.

We may from time to time be
subject to employment claims or disputes.
While there are no such claims or disputes at present, we cannot assure
you that we may not be subject to other lawsuits and actions brought by our
employees or that we would be successful defending against such actions. Any
employment claims could significantly divert our managements time and
attention and could materially affect our business.

Segami Corporation, or
Segami, has developed image processing software for our camera under a
non-exclusive license agreement. While
we have amended our agreement with Segami and now own the image acquisition
software, we remain dependent on Segami for the processing software. In the event that Segami attempts to
terminate the license agreement, refuses to extend the term of the license or
seeks to impose unreasonable pricing or terms, we would have to find an
alternative software system to use in our gamma camera. To our knowledge, there
are a limited number of companies that would be able to develop and implement a
software system similar to what we use in our gamma camera. As a result, in the
event that we were unable to continue to use the software under the license
from Segami, we could have delays in the production of our gamma camera as we
attempted to find a substitute software provider. Furthermore, we cannot
guarantee that alternative software providers would be able to meet our
requirements or that their software would be available to us at favorable
prices, if at all. To the extent we were unable to find an alternative source
for the software, we may have to develop our own software system. We cannot guarantee that we could internally
develop such a software system or that such efforts would not divert resources
away from the development of other features of our camera. As a result,
locating an alternative software system or developing our own software system
could interrupt the manufacture and delivery of our products for an extended
period of time and may cause the loss of customers and revenue.

Many of our employees were
previously employed at other medical device companies, including our
competitors or potential competitors. Although no claims against us are
currently pending, we may be subject to claims that we or our employees have

32

inadvertently or otherwise used or disclosed
trade secrets or other proprietary information of their former employers.
Litigation may be necessary to defend against these claims. Even if we are
successful in defending against these claims, litigation could result in
substantial costs and be a distraction to management. If we fail in defending
such claims, in addition to paying money damages, we may lose valuable
intellectual property rights or personnel. A loss of key research personnel or
their work product could hinder or preclude our ability to commercialize our
products, which could severely harm our business.

Risks
Related to the Securities Markets and Ownership of Our Common Stock

The market price for our
common stock has been and is likely to continue to be volatile. In addition,
the market price of our common stock may fluctuate significantly in response to
a number of factors, most of which we cannot control, including:

volume and
timing of orders for our products and services;

the
introduction of new products, product enhancements, services or technologies by
us or our competitors;

quarterly
variations in our or our competitors results of operations;

conditions or
trends in the medical device industry and the imaging service industry;

disputes or
other developments with respect to intellectual property rights, product
liability claims or other litigation;

our ability to
develop, obtain regulatory clearance for, and market, new and enhanced products
on a timely basis, or changes in governmental regulations or in the status of
our regulatory approvals or applications;

additions or
departures of key personnel;

sales of large
blocks of our common stock, including sales by our executive officers and
directors;

changes in the
availability of third-party reimbursement in the United States or other countries;

changes in
earnings estimates or recommendations by securities analysts; and

general market
conditions and other factors, including factors unrelated to our operating
performance or the operating performance of our competitors.

A small number of our
current stockholders hold a substantial number of shares of our common stock
that they will be able to sell in the public market in the near future. Sales by our current stockholders of a
substantial number of shares, or the expectation that such sale may occur,
could significantly reduce the market price of our common stock. Moreover, the
holders of a substantial number of our shares of common stock, including shares
issued upon the exercise of certain of our warrants, will have rights, subject
to some conditions, to require us to file registration statements to permit the
resale of their shares in the public market or to include their shares in
registration statements that we may file for ourselves or other
stockholders. We have also registered
all common stock that we may issue under our employee benefit plans. Accordingly, these shares can be freely sold
in the public market upon issuance, subject to restrictions under the
securities laws and the lock-up agreements described above. If any of these stockholders cause a large
number of securities to be sold in the public market, the sales could reduce
the trading price of our common stock.
These sales also could impede our ability to raise future capital.

Although we are currently
listed for trading on the Nasdaq National Market, an active trading market for
our common stock may not be sustained. An inactive market
may impair your ability to sell your shares at the time you wish to sell them
or at a price that you consider reasonable. Furthermore, an inactive
market may impair our ability to raise capital by selling shares and may impair
our ability to acquire other businesses, products and technologies by using our
shares as consideration.

Our restated certificate of
incorporation and restated bylaws contain provisions that may delay or prevent
a change in control, discourage bids at a premium over the market price of our
common stock and adversely affect the market price of our common stock and the voting
and other rights of the holders of our common stock. These provisions include:

prohibiting our
stockholders from calling a special meeting of stockholders unless they hold
not less than 20% of the total number of votes to be cast at such a meeting;

permitting the
issuance of additional shares of our common stock or preferred stock without
stockholder approval;

prohibiting our
stockholders from making certain changes to our restated certificate of
incorporation or restated bylaws except with 662/3% stockholder
approval; and

requiring
advance notice for raising matters of business or making nominations at
stockholders meetings.

We are also subject to
provisions of the Delaware corporation law that, in general, prohibit any
business combination with a beneficial owner of 15% or more of our common stock
for five years unless the holders acquisition of our stock was approved in
advance by our board of directors. Although we believe these provisions
collectively provide for an opportunity to receive higher bids by requiring
potential acquirors to negotiate with our board of directors, they would apply
even if the offer may be considered beneficial by some stockholders. In
addition, these provisions may frustrate or prevent any attempts by our stockholders
to replace or remove our current management by making it more difficult for
stockholders to replace members of our board of directors, which is responsible
for appointing the members of our management.

Our officers, directors and
holders of 5% or more of our outstanding common stock beneficially own the
majority of our outstanding common stock. As a result, these stockholders,
acting together, will be able to significantly influence all matters requiring
approval by our stockholders, including the election of directors and the approval
of mergers or other business combination transactions. The interests of this
group of stockholders may not always coincide with our interests or the
interests of other stockholders, and they may act in a manner that advances
their best interests and not necessarily those of other stockholders. As a
result of their actions or inactions our stock price may decline.

Our operations are
headquartered in an approximately 70,000 square foot facility in Poway,
California that is leased to us until February 2010. We believe that our
existing facility is adequate for our current needs.

In January 2005, a complaint
was served on a DIS customer physician, his medical practice and two DIS
technicians, individually and in their capacity as agents of the medical
practice. The complaint was filed in the
Circuit Court of the Fifth Judicial Circuit, County of Vermilion, Danville,
Illinois and alleges negligence claims in connection with the death of a
patient purportedly arising from the administration of a stress imaging
test. We have tendered the matter to the
physician practice for indemnification and defense pursuant to our contract
with the group. While the technicians
deny the allegations and we will vigorously defend them in the matter, if
necessary, we cannot assure you that this matter will be resolved in their
favor.

On November 18, 2004, we
received a notice of violation from the Maryland Department of the Environment,
or Department, relating to our radioactive materials license. The notice alleges violations related
primarily to record-keeping and the failure to follow certain operating
protocols. We responded to the notice
and then participated in a licensee management enforcement conference conducted
by the Department in January 2005. We
have instituted corrective actions and made a supplemental submission to the
Department in February. If the
Department concludes that corrective actions are not adequate, it could take
escalated enforcement action, including the imposition of civil penalties of up
to $10,000 per violation per day, or the modification, suspension or revocation

34

of our license in Maryland. While we believe we have fully addressed each
of the Departments concerns, we cannot assure you that this matter will be
resolved in our favor.

Other than the immediately
preceding discussion, we are not currently a party to any material legal or
other proceedings.

Our common stock has been
traded on the Nasdaq National Market since June 10, 2004 under the symbol DRAD.
Prior to such time, there was no public market for our common stock. The
following table sets forth the high and low closing sales prices for our common
stock as reported on the Nasdaq National Market for the periods indicated.

High

Low

Year Ended December 31, 2004

Second Quarter (beginning
June 10, 2004)

$

11.77

$

9.23

Third Quarter

10.89

7.85

Fourth Quarter

11.12

7.35

As of February 18, 2005,
there were approximately 300 holders of record of our common stock.

We have never declared or
paid cash dividends on our capital stock.
We currently intend to retain all available funds and any future
earnings for use in the operation and expansion of our business and do not
anticipate paying any cash dividends in the foreseeable future.

During the fiscal year ended
December 31, 2004, we issued and sold the following unregistered securities
(not otherwise previously reported in a quarterly report on Form 10-Q or a
current report on Form 8-K):

On February 25, 2004, we
issued warrants to purchase 5,715 shares of our common stock to two consultants
in connection with services rendered to us.
Such warrants have an exercise price equal to $5.50 per share and expire
if not exercised on or before February 25, 2009. The offers, sales and issuances of the warrants
were deemed to be exempt from registration under the Securities Act of 1933, as
amended, in reliance on Rule 701 because the transactions were under
compensatory benefit plans and contracts relating to compensation as provided
under Rule 701. The recipients of the
warrants represented their intention to acquire the securities for investment
only and not with a view to or for sale in connection with any distribution
thereof and appropriate legends were affixed to warrants issued in such
transaction. Each of the recipients of
the warrants were accredited or sophisticated persons and had adequate access,
through employment, business or other relationships, to information about us.

From January 1, 2004 through
March 31, 2004, we granted options to purchase 244,579 shares of common stock
to employees, directors and consultants under our 1998 Stock Option/Stock
Issuance Plan at an exercise price of $5.495 per share. During such period of time, 30,812 shares of
common stock were purchased pursuant to the exercise of stock options for cash
consideration with an aggregate exercise price of $15,098. The offers, sales and issuances of the
options and common stock were deemed to be exempt from registration under the
Securities Act of 1933, as amended, in reliance on Rule 701 because the
transactions were under compensatory benefit plans and contracts relating to
compensation as provided under Rule 701.
The recipients of such options and common stock were our employees,
directors or bona fide consultants and received the securities under our 1998
Stock Option/Stock Issuance Plan.

35

Appropriate
legends were affixed to the share certificates issued in such transactions, and
each of these recipients had adequate access, through employment or other
relationships, to information about us.

We effected the initial
public offering of our common stock pursuant to a Registration Statement on
Form S-1 (File No. 333-113760) that was declared effective by the Securities
and Exchange Commission on June 9, 2004.
On June 15, 2004, 5,500,000 shares of common stock were sold on our
behalf at an initial public offering price of $12.00 per share, for an
aggregate offering price of $66.0 million, which offering was managed by
Merrill Lynch, Pierce, Fenner & Smith Incorporated, J.P. Morgan Securities
Inc., Banc of America Securities LLC and William Blair & Company,
L.L.C. Following the sale of the
5,500,000 shares, the offering terminated.

We paid to the underwriters
underwriting discounts and commissions totaling approximately $4.6 million in
connection with the offering. In
addition, we estimate that we incurred additional expenses of approximately
$2.6 million in connection with the offering, which when added to the
underwriting discounts and commissions paid by us, amounts to total estimated
expenses of approximately $7.2 million.
Thus, the net offering proceeds to us, after deducting underwriting
discounts and commissions and estimated offering expenses, were approximately
$58.8 million. No offering expenses were
paid directly or indirectly to any of our directors or officers (or their
associates) or persons owning ten percent or more of any class of our equity
securities or to any other affiliates.

As of December 31, 2004, we
had used approximately $11.6 million of the net proceeds from our initial
public offering to repay our lines of credit, capital leases and notes payable,
none of which was paid directly or indirectly to any of our directors or
officers (or their associates) or persons owning ten percent or more of any
class of our equity securities or to any other affiliates. In addition, we had used $2.8 million to fund
operations and capital equipment purchases.
We expect to use a majority of the remainder of the net proceeds from
our initial public offering to manufacture and market our gamma cameras, build
our sales and marketing capabilities and expand our business. To a lesser extent, we anticipate using the
remaining net proceeds of the offering:

for further research and
development relating to our existing products and new product opportunities and
to finance regulatory approval activities; and

 for general corporate purposes.

In addition, we may use a
portion of the net proceeds from our initial public offering to acquire
products, technologies or businesses that are complementary to our own, but we
currently have no commitments or agreements relating to any of these types of
transactions.

We cannot specify with
certainty all of the particular uses for the net proceeds received from our
initial public offering. The amount and
timing of our expenditures will depend on several factors, including the amount
of revenue generated from our operations, the progress of our commercialization
efforts, and the amount of cash used in our operations. Accordingly, our management will have broad
discretion in the application of the net proceeds.

Pending the uses described
above, we plan to invest the net proceeds from our initial public offering in
short- and medium-term, interest-bearing obligations, investment-grade instruments,
certificates of deposit or direct or guaranteed obligations of the U.S.
government.

For information concerning
prior stockholder approval of and other matters relating to our equity
incentive plans, see Part III, Item 12 entitled Security Ownership of Certain
Beneficial Owners and Management and Related Stockholder Matters in this
annual report on Form 10-K.

The selected consolidated
financial data set forth below is derived from our audited consolidated
financial statements and may not be indicative of future operating results. The
following selected financial data should be read in conjunction with the
Consolidated Financial Statements for Digirad Corporation and notes thereto and
Item 7, Managements Discussion and Analysis of Financial Condition and
Results of Operations included elsewhere herein. Amounts are in thousands,
except per share amounts.

Years Ended December 31,

Statement of Operations Data:

2004

2003

2002

2001

2000

Revenues:

DIS

$

44,505

$

34,848

$

23,005

$

10,239

$

1,260

Product

23,632

21,388

18,527

18,065

5,815

Total revenues

68,137

56,236

41,532

28,304

7,075

Cost of revenues:

DIS

31,005

24,463

16,599

8,344

839

Product

14,992

15,091

13,633

13,192

9,834

Stock-based compensation

381

114

124

298

65

Total cost of revenues

46,378

39,668

30,356

21,834

10,738

Gross profit (loss)

21,759

16,568

11,176

6,470

(3,663

)

Operating expenses:

Research and development

2,982

2,191

2,967

3,009

2,372

Sales and marketing

7,626

6,008

8,065

9,974

3,586

General and administrative

9,769

8,097

9,497

8,161

2,878

Amortization and impairment of intangible assets

64

444

1,011

991

194

Stock-based compensation

736

112

483

1,281

246

Total operating expenses

21,177

16,852

22,023

23,416

9,276

Income (loss) from operations

582

(284

)

(10,847

)

(16,946

)

(12,939

)

Other income (expense), net

(337

)

(1,396

)

(1,925

)

(2,965

)

(537

)

Net income (loss)

$

245

$

(1,680

)

$

(12,772

)

$

(19,911

)

$

(13,476

)

Net income (loss) applicable to common stockholders

$

84

$

(2,006

)

$

(13,037

)

$

(20,041

)

$

(13,524

)

Basic and diluted net income (loss) per share(1):

$

0.01

$

(127.62

)

$

(1,432.31

)

$

(3,146.16

)

$

(2,527.80

)

Shares used in per share calculations (1):

Basic

10,095

16

9

6

5

Diluted

16,963

16

9

6

5

The composition of stock-based compensation is as follows:

Cost of product revenue

$

165

$

83

$

72

$

200

$

54

Cost of DIS revenue

216

31

52

98

10

Research and development

133

8

61

96

6

Sales and marketing

136

18

228

541

51

General and administrative

467

86

194

644

190

$

1,117

$

226

$

607

$

1,579

$

311

As of December 31,

Balance Sheet Data:

2004

2003

2002

2001

2000

Cash, cash equivalents and securities

$

55,563

$

7,681

$

6,988

$

1,967

$

6,555

Working capital

59,015

2,578

3,781

(1,668

)

5,481

Total assets

86,024

35,159

33,119

29,922

23,050

Total debt

3,982

16,441

13,932

14,469

8,614

Redeemable convertible preferred stock



84,278

83,952

66,531

52,255

Total stockholders equity (deficit)

68,734

(75,703

)

(73,928

)

(61,835

)

(43,479

)

(1)As a result of
the conversion of our preferred stock into 12.4 million shares of our common
stock upon completion of our initial public offering in June 2004, there is a
lack of comparability in the basic and diluted net income (loss) per share
amounts for the periods presented above.
Please refer to Note 1 to our consolidated financial statements
included elsewhere in this Form 10-K for the unaudited pro forma calculation of
basic and diluted net income (loss) per share presented therein.

The
following discussion contains forward-looking statements, which involve risks
and uncertainties. Our actual results could differ materially from those
anticipated in these forward-looking statements as a result of various factors,
including those set forth previously under the caption Risk Factors. This Managements Discussion and Analysis of
Financial Condition and Results of Operations should be read in conjunction
with our consolidated financial statements and related notes included elsewhere
in this report.

We are a leader in the
development, manufacture and distribution of solid-state medical imaging
products and services to physicians offices, hospitals and imaging centers and
were the first company to develop and commercialize a solid-state medical gamma
camera for the detection of cardiovascular disease and other medical
conditions. By using solid-state
technology rather than bulky vacuum tubes, we believe that our imaging systems
produce a high quality image while offering significant advantages over
vacuum-tube based systems, including mobility through reduced size and weight,
enhanced operability and reliability, and improved patient comfort and
utilization. The cameras and accompanying
equipment fit easily into floor spaces as small as seven feet by eight feet and
facilitate the delivery of nuclear medicine procedures directly in a physicians
office, an outpatient hospital setting or within multiple departments of a
hospital.

Our revenues are generated within two primary
operating segments: our DIS business and product sales. DIS collectively refers
to our wholly-owned subsidiaries, Digirad Imaging Solutions, Inc. and Digirad
Imaging Systems, Inc. Through DIS, we offer FlexImaging, our mobile and
comprehensive leasing service for physicians who wish to perform nuclear
cardiology and nuclear medicine procedures in their offices, but do not have
the patient volume, capital or personnel to justify purchasing an imaging
system. DIS leasing services are currently provided in 18 states and the
District of Columbia. Physicians enter into annual contracts for imaging
services delivered on a per-day basis. Our typical annual lease contracts
provide, on average, for one day of service per week, adjusted for holidays and
vacations. We believe DIS allows us to
avoid the often lengthy and sometimes unpredictable sales cycle associated with
capital equipment sales in a hospital or physician practice setting. We experience some seasonality in our DIS
business as a result of holidays, inclement weather and summer slowdowns,
principally relating to vacations. Historically, these variables have had the
most effect on our third quarter operating results.

Our product revenue results
primarily from selling solid-state gamma cameras, imaging chairs, upgrades and
accessories, such as printers, viewing workstations and networking solutions,
and from our maintenance contracts. We sell our imaging systems to physician
offices, hospitals and imaging centers primarily in the United States, although
we have sold a small number of imaging systems internationally. Currently, we purchase some components from
sole source providers but are either qualifying or seeking second source
providers in an effort to limit our reliance on these suppliers.

In 2000, we sold our first solid-state gamma camera
and launched our DIS business. From 2000 to 2004, our consolidated annual
revenues grew from $7.1 million to $68.1 million. DIS and product revenues accounted for 65.3%
and 34.7%,respectively, of our consolidated
revenues for the year ended December 31, 2004, compared to 62.0% and
38.0%, respectively, of our consolidated revenues for the prior year.

Consolidated revenue increased 21.2% to $68.1 million
in 2004, primarily as a result of sales growth in our DIS business. We experienced significant improvement in
gross profit margin, principally as a result of decreased production costs and
warranty expense attributable to product reliability improvements in our
product business. As a result, we
achieved our first full year of profitability in 2004, recording net income of
$0.2 million as compared to a net loss of $1.7 million in 2003. Other significant highlights during 2004
included the consolidation of our manufacturing sites, research and development
group, and corporate headquarters from several facilities to a single facility
in Poway, California, the completion of our initial public offering in June and
the expansion of our DIS business through the addition of five new DIS hubs and
sites during the course of the year.

In September, we also introduced the Cardius-3, our
dedicated cardiac triple-head camera which we believe is the only such camera
currently on the market. The Cardius-3 imager provides high count imaging
statistics and higher patient throughput.
It is capable of a sub-seven minute stress acquisition and thus, well
suited for high volume cardiology practices, hospitals and outpatient imaging
centers. We sold the first two systems
in the fourth quarter of 2004 and believe the systems speed, improved
throughput and flexibility will provide us significant advantages in seeking to
penetrate the hospital and larger cardiology practice markets.

38

During 2004, our DIS business performed more than
89,000 studies. We also saw an increase
in year-over-year gross profit as a percentage of revenue. In May 2004, we launched DigiTech, a
personnel-only leasing service we offer to physicians who have purchased a
Digirad camera. DigiTech was priced at a
lower per-day fee than our traditional DIS FlexImaging lease service offering,
which led to a decline in our overall DIS gross margin during the second half
of 2004. Recognizing the value the
DigiTech program brings to customers, we have now re-priced the program and
anticipate this action to result in higher per-day revenue and margins in the
future. We expect the impact of the
lower-margin DigiTech contracts to decline to insignificant levels by the end
of the second quarter of 2005. To a
lesser extent, DIS gross profit and system utilization were also affected by
expenses incurred to expand DIS operations, and by an increased number of DIS
physicians purchasing cameras in the third quarter of 2004. We believe that margins will increase as
system utilization in the new geographies increases.

According to industry
sources, 18.4 million nuclear imaging procedures were performed in the United
States in 2003, of which 10.2 million procedures were cardiac applications, a
volume that is expected to grow by approximately 8% annually through 2005. We
believe the growth in nuclear cardiology imaging will be driven by an increase
in coronary heart disease resulting from the aging of baby boomers and the
record rate of obesity and diabetes in all age groups. We estimate that the 2004 growth rate for
nuclear cardiology procedures performed in physician offices was approximately
15%, and that the growth rate in hospitals was approximately 4%. These growth rates have slowed considerably
in the last two years. Nonetheless, we
believe that the small size, mobility and throughput flexibility of our imaging
systems offer us a significant competitive advantage in capitalizing on the
shift in delivery of nuclear cardiology imaging services from hospitals to
physician offices. The target market for
our products and services is the approximately 30,000 cardiologists in the
United States that perform or could perform nuclear cardiology procedures, and
we seek to increase our market penetration rate significantly. To date, we have
sold or provided imaging services through DIS to approximately 600 physicians,
or approximately 2% of cardiologists. In
2004, DIS performed over 89,000 patient procedures, which was approximately 1%
of the cardiac nuclear imaging procedures we estimate were performed in the
United States during that year.

Our market may be affected by continuing pressures by
third party payors to reduce health care expenditures. For example, we are aware of a third party
payor in a geographic location currently served by us that recently issued
guidelines prohibiting our physician customers from obtaining reimbursement for
procedures they perform unless they own or lease our cameras on a full time
basis. This payor is also requiring
physicians to obtain accreditation or certification by either the Intersocietal
Commission for the Accreditation of Nuclear Medicine Laboratories or the
American College of Radiology, and to meet certain other privileging standards,
in order to obtain reimbursement for nuclear imaging procedures. The adoption of similar restrictions in other
jurisdictions or by other payors, including Medicare, could force us to change
our business model.

We expect the majority of DIS growth in 2005 to come
from our standard DIS FlexImaging service. Given our strategy to continue to
expand the number of areas in which we offer DIS services and the recurring
contractual revenue stream from our existing DIS business, we expect DIS
revenue to continue to represent the majority of our consolidated revenues and
to generate a majority of our consolidated earnings. We attribute the overall
growth of our business to geographical expansion, increased market penetration,
awareness and acceptance of our services and products, and the shift in the
delivery of nuclear cardiology imaging procedures from hospitals to physician
offices. We believe that the increase in
demand for our services and products is driven by the desire of cardiologists
to control their patients diagnosis and treatment and to retain revenue for
services that would otherwise be performed by a hospital or imaging center. The
mobile feature of our technology also provides us with a significant advantage
in the delivery of nuclear cardiology imaging services.

In 2005, we will focus on DIS expansion,
margin improvement, customer care and clinical leadership in our
field. We will continue to invest in research and development
initiatives to reduce product costs, enhance reliability and improve
system sensitivity. Because we own the products that we lease, we
have at times been able to translate technical camera improvements into
increased margins in our DIS business.
For example, our recently introduced Cardius-3 triple-head camera
features high count imaging statistics and higher patient throughput. We believe that a mobile version of the
Cardius-3 now under development, subject to its successful beta-testing in the
first half of 2005 and incremental roll-out into DIS in the second half of
2005, may result in improved revenue and higher margins in DIS.

Consolidated. Consolidated
revenues in 2004 increased to $68.1 million from $56.2 million in
2003, which represents an increase of $11.9 million, or 21.2%, primarily as a
result of increased demand for our DIS services and our Cardius products. We
believe that this increased demand was principally a result of increased
customer awareness and acceptance of our products and services. DIS and product revenue accounted for 65.3%
and 34.7%, respectively, of total revenues in 2004, compared to 62.0% and
38.0%, respectively, in 2003. We expect DIS revenue to continue to represent a
larger percentage of consolidated revenue.

DIS. Our DIS revenue
increased to $44.5 million in 2004 from $34.8 million in 2003, which
represents an increase of $9.7 million, or 27.7%. The increase in DIS
revenue resulted from an increase in the number of DIS service days to 12,003
for the year ended December 31, 2004 from 9,425 for the year ended
December 31, 2003, which was primarily attributable to an increase in the
number of physicians purchasing our DIS services. To respond to this demand, we
deployed 17 additional systems in the year ended December 31, 2004. DIS
revenue accounted for 65.3% of total revenues in 2004 versus 62.0% in 2003.
Collectively, our DIS business operated 71 mobile and fixed site systems as of
December 31, 2004. Although average
DIS revenue per day increased in 2004 as compared to 2003, the mid-2004 launch
of our DigiTech leasing program, a personnel only service offered by DIS to
physicians who have purchased a Digirad camera that is priced at a lower
per-day fee than our traditional FlexImaging service offering, resulted in a
decline in average DIS revenue per day during the second half of 2004. We continue to anticipate that our DIS
revenue will increase as we expand into new markets and continue to penetrate
existing markets. Such growth will fluctuate, however, based on seasonality
stemming from physician vacations, holidays, inclement weather and start up
time required by sales representatives as we enter new geographies.

Product. Our
product revenue increased to $23.6 million in 2004 from $21.4 million
in 2003, which represents an increase of $2.2 million, or 10.5%. This increase
was due to increased sales of our gamma cameras, maintenance contract revenue,
and, for the first time, upgrades from single-head cameras to multi-head
cameras. We sold 85 cameras, not including upgrades, in 2004, compared to 79
cameras, without upgrades in 2003. In
2004, we recorded revenue associated with the delivery of our first two
Cardius-3 systems. Product revenue
accounted for 34.7% of total revenues for 2004 versus 38.0% in 2003.
Maintenance contract revenues were $3.4 million in 2004 and $2.1 million in 2003. We have experienced pricing pressures on our
dual-head gamma cameras and, while we expect this pricing pressure to continue,
we also anticipate demand will continue to increase, primarily for our Cardius family
of

40

products, potentially reducing or offsetting
the effects of these pricing pressures.

Gross Profit

Consolidated. Consolidated
gross profit increased to $21.8 million in 2004 from $16.6 million in
2003, which represents an increase of $5.2 million, or 31.3%. Consolidated
gross profit as a percentage of revenue increased to 31.9% in 2004 from 29.5%
in 2003 primarily as a result of an increase in revenue, and reductions in
gamma camera production costs and per unit warranty costs.

DIS. Cost of DIS revenue
consists primarily of labor, radiopharmaceuticals, equipment depreciation and
other costs associated with the provision of services. Cost of DIS revenue increased to
$31.0 million in 2004 from $24.5 million in 2003, representing an increase
of $6.5 million, or 26.7%. DIS gross profit increased to $13.5 million in
2004 from $10.4 million in 2003, which represents an increase of $3.1
million, or 30.0%, as a result of increased volumes. Our clinical and regulatory headcount
relating to our DIS business increased to 163 employees at the end of 2004 from
137 employees at the end of 2003. DIS gross profit as a percentage of revenue
increased to 30.3% in 2004 from 29.8% in 2003.
Although DIS gross profit as a percentage of revenue increased on a
year-over-year basis, it declined in the second half of 2004 as a result of
lower margin DigiTech leases and, to a lesser degree, to a decline in system
utilization resulting from the expansion of our operations and an increased
number of DIS customers purchasing nuclear gamma cameras in the third quarter
of 2004. Although we anticipate that we
will continue to offer DigiTech lease services, we have re-priced the offering
and anticipate an improvement in revenue per day and gross margin. We expect the majority of the DIS growth in
2005 to come from our standard DIS FlexImaging service.

Product. Cost
of goods sold primarily consists of materials, labor and overhead costs
associated with the manufacturing and warranty of our products. Warranty costs
are charged to cost of goods sold in the period our cameras are sold and are
based on our historical experience with failure rates and repair costs. Cost of goods sold decreased to
$15.0 million in 2004 from $15.1 million in 2003, which represents a
decrease of $0.1 million, or 0.7%. Product gross profit increased to
$8.6 million in 2004 from $6.3 million in 2003, which represents an
increase of $2.3 million, or 37.2%, primarily as a result of increased
manufacturing volumes and reduced per unit costs resulting from lower warranty
costs, fewer and less expensive materials and more efficient manufacturing
processes used to build our third-generation camera heads introduced in
July 2003. Our third-generation camera heads consist of fewer and less expensive
materials than our earlier generation camera heads and are produced using more
efficient processes that have reduced labor and overhead costs compared to
historical rates. Product gross profit as a percentage of revenue increased to
36.6% in 2004 from 29.4% in 2003.

Operating
Expenses

Research and Development. Research and
development expenses consist primarily of costs associated with the design,
development, testing, and enhancement of our products. The primary costs are
salaries and fringe benefits, consulting fees, facilities and overhead costs
and nonrecurring engineering costs.
Research and development expenses increased to $3.0 million in 2004 from
$2.2 million in 2003, which represents an increase of $0.8 million, or
36.1%. This increase was primarily
attributable to increased employee headcount to develop new products such as
the Cardius-3 which was introduced into the marketplace at the end of the third
quarter of 2004. Research and
development headcount increased to 22 employees in 2004 from 16 employees in
2003. Our research and development
efforts occur principally within our products segment. In the future, we expect to continue to
invest between approximately 10% and 13% of the revenue of this segment on
research and development as we innovate and seek to continue to improve our
existing technology.

Sales and Marketing. Sales
and marketing expenses consist primarily of salaries, commissions, bonuses,
recruiting costs, travel, marketing and collateral materials and tradeshow
costs. Sales and marketing expenses
increased to $7.6 million in 2004 from $6.0 million in 2003,
representing an increase of $1.6 million, or 26.9%. This increase was primarily attributable to
an increase in the number of sales and marketing personnel and the expansion of
our marketing efforts. In 2004, sales
and marketing expenses were 11.2% of total revenue versus 10.7% in 2003. We expect to increase our sales and
marketing effort, as we expand the locations in which we expect to perform DIS
services and focus on increasing market awareness of our products and
offerings, including the recently released Cardius-3.

General
and Administrative. General
and administrative expenses consist primarily of salaries and other related
costs for finance and accounting, human resources and other personnel, as well
as legal and other professional fees and insurance. General and administrative
expenses increased to $9.8 million in 2004 from $8.1 million in 2003,
which represents an increase of $1.7 million, or 20.6%. Increases in headcount and recruiting costs,
insurance, professional fees and other costs primarily related to operating as
a public company all contributed to increased general and administrative
expenses. General and administrative
headcount was increased by 15 employees by the end of 2004 to 48 employees
versus 33 employees at the end of 2003. In 2004, general and administrative
expenses amounted to 14.3% of total revenue which represented a slight decrease
from 14.4% in 2003. As a result of our
initial public offering, we will be required to incur additional general and
administrative costs in the future to meet various public reporting and
compliance requirements. In addition, in
the normal course of business, we have been and will likely continue to be

41

subject to routine
litigation incidental to our business, such as claims related to customer
disputes, employment practices, product liability, warranty or patent
infringement. As we continue to grow, we anticipate that the volume of these
claims is likely to increase at a corresponding rate. The substantial costs of litigation or an
unexpected adverse outcome could materially increase our anticipated operating
expenses.

Amortization
and Impairment of Intangible Assets. Amortization
and impairment of intangibles decreased to $0.1 million in 2004 from
$0.4 million in 2003. The decline from 2003 to 2004 was principally a
result of impairment charges recorded in 2003 associated with purchased contracts.

Stock-Based Compensation Charges. Deferred
compensation for stock options granted to employees has been determined as the
difference between the exercise price and the fair value of our common stock on
the date of grant. Options or awards issued to non-employees are recorded at
their fair value in accordance with SFAS No. 123 and periodically
remeasured in accordance with EITF 96-18 and recognized over the respective
service or vesting period. These amounts are initially recorded as a component of
stockholders equity and are amortized, on an accelerated basis, as a non-cash
charge to cost of revenues and operations over the vesting period of the
options. In connection with the grant of
stock options to employees, we recorded as amortization of stock-based
compensation of $1.1 million and $0.2 million for the years ended
December 31, 2004 and 2003, respectively.

Interest income increased to
$0.6 million in 2004 from negligible amounts in 2003, primarily due to higher
average cash and investment balances in 2004 as a result of our initial public
offering, which closed in June 2004.

Interest expense decreased
to $0.9 million in 2004 from $1.4 million in 2003, which represents a
decrease of $0.5 million, or 38.0%. The reduction is a result of lower balances
on our two credit lines and a reduction of amounts outstanding under capital
leases.

Consolidated. Consolidated
revenues in 2003 increased to $56.2 million from $41.5 million in
2002, which represents an increase of $14.7 million, or 35.4%, primarily
as a result of increased demand for our DIS services and our Cardius products.

DIS. Our DIS revenue
increased to $34.8 million in 2003 from $23.0 million in 2002, which
represents an increase of $11.8 million, or 51.5%. The increase in DIS
revenue resulted from an increase in the number of DIS service days from 6,567
for the year ended December 31, 2002 to 9,425 for the year ended
December 31, 2003, which was primarily attributable to an increase in the
number of physicians purchasing our DIS services. To respond to this demand, we
deployed eight additional mobile systems in the year ended December 31,
2003. DIS revenue accounted for 62.0% of total revenues in 2003 versus 55.4% in
2002. Collectively, our DIS business operated 54 mobile and fixed site systems
as of December 31, 2003.

Product. Our
product revenue increased to $21.4 million in 2003 from $18.5 million
in 2002, which represents an increase of $2.9 million, or 15.4%. This
increase was due to increased sales of our gamma cameras and maintenance
contract revenue. We sold 79 cameras in 2003 compared to 75 cameras in 2002.
Product revenue accounted for 38.0% of total revenues for 2003 versus 44.6% in
2002. Maintenance contract revenues were $2.1 million in 2003 and $521,000
in 2002.

Gross
Profit

Consolidated. Consolidated
gross profit increased to $16.6 million in 2003 from $11.2 million in
2002, which represents an increase of $5.4 million, or 48.2%. Consolidated
gross profit as a percentage of revenue increased to 29.5% in 2003 from 26.9%
in 2002 primarily as a result of an increase in revenue, lower per unit DIS
imaging service cost and product cost reductions.

DIS. Our clinical and
regulatory headcount relating to our DIS business increased to 137 employees at
the end of 2003 from 112 employees at the end of 2002. Cost of DIS revenue
increased to $24.5 million in 2003 from $16.6 million in 2002, which
represents an increase of $7.9 million, or 47.4%. DIS gross profit
increased to $10.4 million in 2003 from $6.4 million in 2002, which
represents an increase of $4.0 million, or 62.1%, as a result of increased
volumes and reductions in the per unit cost of various items consumed in
providing the imaging services. DIS gross profit as a percentage of revenue increased
to 29.8% in 2003 from 27.8% in

42

2002.

Product. Cost of
goods sold increased to $15.1 million in 2003 from $13.6 million in
2002, which represents an increase of $1.5 million, or 10.7%. Product
gross profit increased to $6.3 million in 2003 from $4.9 million in
2002, which represents an increase of $1.4 million, or 28.6%, as a result
of the increase in the volume of cameras produced, fewer and lower-cost
materials and more efficient manufacturing processes due to the introduction of
our third-generation camera heads. Our third-generation camera heads consist of
fewer and lower-cost materials than our earlier generation camera heads and are
produced using more efficient processes that have reduced overhead and labor
costs compared to historical rates. Product gross profit as a percentage of
revenue increased to 29.4% in 2003 from 26.4% in 2002.

Operating
Expenses

Research and Development. Research
and development expenses decreased to $2.2 million in 2003 from
$3.0 million in 2002, which represents a decrease of $776,000, or 26.2%,
primarily as a result of our efforts to develop and launch our Cardius camera
product line in 2002. Research and development headcount increased to 16
employees in 2003 from 14 employees in 2002.

Sales and Marketing. Sales
and marketing expenses decreased to $6.0 million in 2003 from
$8.1 million in 2002, which represents a decrease of $2.1 million, or
25.5%. In late 2002, we restructured the management of the sales organization
and modified the compensation structure, resulting in a significant reduction
in sales expense both in dollars and as a percent of revenue. In 2003, sales
and marketing expenses were 10.7% of total revenue versus 19.4% in 2002.

General and Administrative. General
and administrative expenses decreased to $8.1 million in 2003 from
$9.5 million in 2002, which represents a decrease of $1.4 million, or
14.7%. Reduced outside legal expenses, which were partially offset by the
addition of in-house general counsel, and a reduction in headquarters
headcount, all contributed to lower general and administrative expenses.
General and administrative headcount was reduced by one employee by the end of
2003 to 33 employees versus 34 employees at the end of 2002. In 2003, general
and administrative expenses amounted to 14.4% of total revenue versus 22.9% in
2002.

Amortization and Impairment of Intangible Assets. Amortization
and impairment of intangibles decreased to $444,000 in 2003 from
$1.0 million in 2002. The significant decline from 2002 to 2003 was
principally a result of impairment charges recorded in 2002 associated with
these purchased contracts.

Stock-Based Compensation Charges. In
connection with the grant of stock options to employees, we recorded as
amortization of stock-based compensation of $226,000 and $606,000 for the years
ended December 31, 2003 and 2002, respectively.

Interest expense decreased
to $1.4 million in 2003 from $2.0 million in 2002, which represents a
decrease of $558,000, or 28.1%. The reduction is a result of a decrease in the
variable interest rates on two accounts receivable credit lines and a reduction
on capital leases, and $243,000 of debt discount associated with our
$1.9 million bridge financing in 2002.

Interest income decreased to
$35,000 in 2003 from $65,000 in 2002, which represents a decrease of $30,000,
or 45.6%, primarily due to lower interest rates in 2003 on cash and cash
equivalent accounts.

We require capital
principally for working capital, debt service and capital expenditures. Working capital is required principally to
finance accounts receivable and inventory.
Our working capital requirements vary from period to period depending on
manufacturing volumes, the timing of deliveries and the payment cycles of our
customers. Our capital expenditures
consist primarily of DIS cameras and vans, computer hardware and software. We have historically funded our operations
principally through private placements of equity securities. We completed seven private placements of
preferred stock between March 1995 and June 2002, yielding aggregate
net proceeds of approximately $83.5 million. In June 2004, we completed
our initial public offering and received net proceeds of $58.8 million, a
portion of which were used to retire existing debt. Based upon our current level of expenditures,
we believe the proceeds from our initial public offering, together with cash
flows from operating activities will be adequate to meet our

43

anticipated cash requirements for working
capital, debt service and capital expenditures for at least the next 12 months.

As of December 31,
2004, cash and cash equivalents and investments totaled $55.6 million
compared to $7.7 million at December 31, 2003. We currently invest
our cash reserves in money market funds, high-grade auction rate securities and
U.S. government or corporate debt securities.

Net cash provided by
operations was $6.0 million in 2004. Net
cash provided by operating activities during 2004 was primarily the result of
the improvement in our operating results, a decrease in accounts receivable and
increases in inventory and accounts payable, augmented by non-cash items such
as depreciation and amortization of stock-based compensation.

Accounts receivable were
$10.0 million and $12.2 million at December 31, 2004 and 2003,
respectively. The decrease at the end of 2004 compared to the end of 2003, was
as the result of a reduction in DSO at both our DIS and product businesses. Inventories were $7.0 million and
$3.7 million at December 31, 2004 and 2003, respectively. The
increase at the end of 2004 compared to the end of 2003 was a result of our
carrying more inventories at the end of 2004 as we ramp up for anticipated
growth. The increase in accounts payable is primarily associated with increased
operational volumes.

Net cash used in investing
activities amounted to approximately $48.8 million in 2004, and reflects the
investment of the proceeds from our initial public offering and capital
expenditures primarily associated with our DIS operations.

Net cash provided by
financing activities amounted to approximately $46.4 million in 2004. Proceeds
from the initial public offering less amounts paid under credit line borrowings
and capital lease obligations and notes payable to stockholders were primarily
responsible for the net cash provided by financing activities in 2004. Subsequent to December 31, 2004, we repaid
$2.0 million of our capital lease obligations in advance of their scheduled
maturity.

As of December 31,
2004, we had capital lease obligations totaling $4.0 million. These
obligations are secured by the specific equipment financed under each lease and
will be repaid monthly over the lease terms, which range from 36 to 63 months.
Our DIS subsidiary entered into the majority of these capital lease
obligations.

We are committed to making
future cash payments on capital leases (including interest) and operating
leases. We have not guaranteed the debt of any other party. The following table
summarizes our contractual obligations as of December 31, 2004 (dollars in
thousands):

Payments Due by Period

Contractual obligations

Total

Less than 1 year

1-3 years

3-5 years

More than 5 years

Capital lease obligations

$

4,441

$

3,240

$

1,105

$

96

$



Operating lease obligations

3,595

905

1,502

1,096

92

Total

$

8,036

$

4,145

$

2,607

$

1,192

$

92

Subsequent
to December 31, 2004, we repaid $2.0 million of our capital lease obligations
in advance of their scheduled maturity.

The Securities and Exchange
Commission defines critical accounting policies as those that are, in
managements opinion, very important to the portrayal of our financial
condition and results of operations and require our managements most
difficult, subjective or complex judgments. In preparing our financial
statements in accordance with generally accepted accounting principles in the
United States, we must often make estimates and assumptions that affect the
reported amounts of assets, liabilities, revenue, expenses and related
disclosures at the date of the financial statements and during the reporting
period. Some of those judgments can be subjective and complex. Consequently, actual
results could differ from our estimates. The accounting policies that are most
subject to important estimates or assumptions include those described below.

We recognize revenue in
accordance with Staff Accounting Bulletin No. 104 when all of the
following four criteria are met:

1. A contract or
sales arrangement exists;

2. Products have
been shipped and title has transferred or services have been rendered;

3. The price of
the products or services is fixed or determinable; and

44

4. Collectibility
is reasonably assured.

Our DIS revenue is recorded
once the services and disposables are provided and consumed, which is normally
on the day of the service. For our product revenue, these criteria are usually
met upon delivery. Reductions to our DIS
revenue are recorded to provide for payment adjustments and credit memos. In
addition, we establish reserves against our DIS revenue to allow for uncollectible
items relating to patient co-payments and contractual allowances and other
adjustments, based on historical collection experience. Reductions to product
revenue are recorded to provide for payment adjustments and credit memos and
historically have not been significant.

Historically, the need to
estimate reserves for accounts receivable has been limited to our DIS business.
We provide reserves for billing adjustments, contractual allowances and
doubtful accounts. DIS payment adjustments and credit memos are adjustments for
billing errors that are normally adjusted within the first 90 days
subsequent to the performance of service, with the majority occurring within
the first 30 days. Reserves are provided as a percentage of DIS revenue
based on historical experience rate. We primarily bill the physicians under
contract directly, but in a minority of cases, we were reimbursed under
government programs, Medicare or by private insurance companies. We provide
reserves for contractual allowances for billings to Medicare and insurance
companies based on our collection experience rates. We use a combination of
factors in evaluating the collectibility of accounts receivable. Each account
is reviewed on at least a quarterly basis and a percentage varying from zero to
100% for each account is established. We do not establish reserves for accounts
with a history of payment without disputes. We generally reserve between 15%
and 100% of the outstanding balance for accounts that are more than
180 days late and/or under dispute. We reserve 100% of the outstanding
balance for accounts that we believe constitute a high risk of default based on
factors such as level of dispute, payment history and our knowledge of a
customers inability to meet its obligations. We also consider bad debt
write-off history. Our estimates of collectibility could be reduced by material
amounts by changed circumstances, such as a higher number of defaults or
material adverse changes in a payors ability to meet its
obligations. The provisions for billing adjustments and contractual
allowances are charged against DIS revenues and the provision for doubtful
accounts is charged to general and administrative expenses.

We state property and equipment
and purchased contracts at cost. We capitalize betterments, which extend the
useful life of the equipment. We calculate depreciation on property and
equipment and purchased contracts on the straight-line method over the
estimated useful live (three to seven years for property and equipment and five
years for purchased contracts) of the assets. We follow Financial Accounting
Standards Board (FASB) Statement of
Financial Accounting Standards (SFAS) No. 144, Accounting for Impairment
or Disposal of Long-Lived Assets, which requires impairment losses
to be recorded on long-lived assets used in operations when indicators of
impairment are present and the undiscounted cash flows estimated to be
generated by those assets are less than the assets carrying amount. If such
assets are considered to be impaired, we measure the impairment be recognized
by the amount by which the carrying amount of the assets exceeds the estimated
fair value of the assets. We have taken impairment charges on certain customer
contracts purchased during 2000 from Nuclear Imaging Systems, Inc. and
Florida Cardiology, Inc. Assets are examined for impairment annually or
more frequently if events occur that may indicate a potential asset impairment.

We state inventories at the
lower of cost (first-in, first-out) or market (net realizable value). Costs
include material, labor and manufacturing overhead costs. We review our inventory balances monthly for
excess sale products or obsolete inventory levels. Except where firm orders are
on-hand, we consider inventory quantities of sale products in excess of the
next 12 months demand as excess and reserve for them at levels between
20% and 50% of cost, depending on our knowledge and forecast for the product.
We establish obsolescence reserves on an increasing basis from 0% for active,
high-demand products, to 100% for obsolete products. We review the reserve
periodically and, if necessary, make adjustments. We rely on historical
information to support our reserve and utilize managements business judgment.
Once the inventory is written down, we do not adjust the reserve balance until
the inventory is sold.

We provide a warranty on
certain of our products and accrue the estimated cost at the time revenue is
recorded. Historically, the warranty periods have ranged from 12 months up to
24 months. Since July 2002, substantially all of the warranty periods have
been 12 months before customer-sponsored maintenance begins. Warranty
reserves are established based on historical experience with failure rates and
repair costs and the number of units at customers covered by warranty. We
review warranty reserves monthly and, if necessary, make adjustments.

In December 2004, the
Financial Accounting Standards Board (FASB) issued FASB Statement No. 123
(revised 2004), Share Based Payment (SFAS
123R), which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation (SFAS
123). This statement supercedes APB Opinion 25, Accounting for Stock Issued to Employees (APB
25), and amends FASB Statement No. 95, Statement
of Cash Flows. Generally, the approach in SFAS 123R is similar
to the approach described in SFAS 123; however, SFAS 123R requires all
share-based payments to employees, including grants of employee stock options,
to be recognized in the income statement based on their fair values. Pro
forma disclosure is no longer an alternative.

SFAS 123R permits companies
to adopt its requirements using either a modified prospective method or a modified
retrospective method. Under the modified prospective method,
compensation cost is recognized in the financial statements beginning with the
effective date, based on the requirements of SFAS 123R for all share-based
payments granted after that date, and based on the requirements for SFAS 123
for all unvested awards granted prior to the effective date of SFAS 123R.
Under the modified retrospective method, the requirements are the same as
under the modified prospective method, but also permits companies to restate
financial statements of previous periods based on pro forma disclosures made in
accordance with SFAS 123. We currently utilize the Black-Scholes model to
measure the fair value of stock options granted to employees under the pro
forma disclosure requirements if FAS 123. While SFAS 123R permits
companies to continue to use such model, it also permits the use of a lattice
model. We have not yet determined which method or model it will use to
measure the fair value of employee stock options under the adoption for SFAS
123R. The new standard is effective for periods beginning after June 15,
2005, and we expect to adopt SFAS 123R on July 1, 2005.

We currently account for
share-based payments to employees using APB 25s intrinsic value method and, as
such, recognize no compensation cost for employee stock options granted with
exercise prices equal to or greater than the fair value of our common stock on
the date of the grant. Accordingly, the adoption of SFAS 123Rs fair
value method is expected to result in significant non-cash charges which will
increase our reported cost of revenues and operating expenses, however, it will
have no impact on our cash flows. The impact of adoption of SFAS 123R
cannot be predicted at this time because it will depend on the level of
share-based payments granted in the future and the model we choose to use.
However, had we adopted SFAS 123R in prior periods, the impact of that
standard would have approximated the impact of SFAS 123 as described in the
disclosure of pro forma net loss and earnings above.

Our exposure to market risk
due to changes in interest rates relates primarily to the increase or decrease
in the amount of interest income we can earn on our investment portfolio. Our
risk associated with fluctuating interest rates is limited to our investments
in interest rate sensitive financial instruments. Under our current policies,
we do not use interest rate derivative instruments to manage exposure to
interest rate changes. We attempt to increase the safety and preservation of
our invested principal funds by limiting default risk, market risk and
reinvestment risk. We mitigate default risk by investing in investment grade
securities. A hypothetical 100 basis point adverse move in interest rates along
the entire interest rate yield curve would not materially affect the fair value
of our interest sensitive financial instruments due to their relatively short
term nature. Declines in interest rates over time will, however, reduce our
interest income while increases in interest rates over time will increase our
interest income.

We maintain disclosure
controls and procedures that are designed to ensure that information required
to be disclosed in our Exchange Act reports is recorded, processed, summarized
and reported within the time periods specified in the Securities and Exchange
Commissions rules and forms and that such information is accumulated and
communicated to our management, including our chief executive officer and chief
financial officer, as appropriate, to allow for timely decisions regarding
required disclosure. In designing and evaluating the disclosure controls and
procedures, management recognizes that any controls and procedures, no matter
how well designed and operated, can provide only reasonable assurance of
achieving the desired control objectives, and management

46

is required to apply its judgment in
evaluating the cost-benefit relationship of possible controls and procedures.

As required by Securities
and Exchange Commission Rule 13a-15(b), we carried out an evaluation,
under the supervision and with the participation of our management, including
our chief executive officer and chief financial officer, of the effectiveness
of the design and operation of our disclosure controls and procedures as of the
end of the period covered by this report. Based on the foregoing, our chief
executive officer and chief financial officer concluded that our disclosure
controls and procedures were effective at the reasonable assurance level.

There has been no change in
our internal controls over financial reporting during our most recent fiscal
quarter that has materially affected, or is reasonably likely to materially
affect, our internal controls over financial reporting.

The information required by
this item will be contained in our definitive proxy statement to be filed with
the Securities and Exchange Commission in connection with the Annual Meeting of
our Stockholders (the Proxy Statement), which is expected to be filed not
later than 120 days after the end of our fiscal year ended
December 31, 2004, and is incorporated in this report by reference.

Certification of Chief
Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated
pursuant to the Securities Exchange Act of 1934, as amended.

31.2

Certification of Chief
Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated
pursuant to the Securities Exchange Act of 1934, as amended.

32.1

Certification of Chief
Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2

Certification of Chief
Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(1)

This exhibit was previously
filed as an exhibit to the Companys quarterly report on Form 10-Q originally
filed with the Commission on August 11, 2004, as amended thereafter, and is
incorporated herein by reference.

(2)

This exhibit was
previously filed as an exhibit to the Registration Statement on Form S-1
(File No. 333-113760) originally filed with the Securities and Exchange
Commission on March 19, 2004, as amended thereafter, and is incorporated
herein by reference.

(3)

This exhibit was
previously filed as an exhibit to the Companys quarterly report on Form 10-Q
filed with the Commission on November 2, 2004, and is incorporated herein by
reference.

(4)

This exhibit was
previously filed as an exhibit to the Companys current report on Form 8-K
filed with the Commission on September 7, 2004, and is incorporated herein by
reference.



Digirad Corporation has
been granted confidential treatment with respect to certain portions of this
exhibit (indicated by asterisks), which have been filed separately with the
Commission.

+

Portions of this exhibit
(indicated by asterisks) have been omitted pursuant to a request for
confidential treatment and have been separately filed with the Commission.

Pursuant to the requirements
of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant
has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

DIGIRAD
CORPORATION

Dated: March 3, 2005

By:

/s/ David M. Sheehan

Name:

David M. Sheehan

Title:

President and Chief Executive
Officer

Pursuant to the requirements
of the Securities Exchange Act of 1934, this report has been signed by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated:

We have
audited the accompanying consolidated balance sheets of Digirad Corporation as
of December 31, 2004 and 2003, and the related consolidated statements of
operations, changes in stockholders equity (deficit), and cash flows for each
of the three years in the period ended December 31, 2004. Our audits also include the financial
statement schedule listed in the Index at Item 15(a). These financial statements are the
responsibility of the Companys management. Our responsibility is to express an
opinion on these financial statements based on our audits.

We conducted
our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement.
An audit includes consideration of internal control over financial
reporting as a basis for designing audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the
effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An
audit also includes examining, on a test basis, evidence supporting the amounts
and disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our
opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Digirad Corporation
at December 31, 2004 and 2003, and the consolidated results of its operations
and its cash flows for each of the three years in the period ended December 31,
2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the financial statement
schedule, when considered in relation to the basic financial statements taken
as a whole, presents fairly, in all material respects, the information set
forth therein.